As the battle of the economic forecasts rages on, it’s useful to note that (right now, anyway), the predictions aren’t all that different. The more optimistic scenarios, like the one published by EY ITEM Club today, suggest the UK will see minuscule growth this year but avoid technical recession. The pessimistic scenarios, like the IMF’s latest forecast, are being revised upwards but still show the UK economy experiencing a short and shallow contraction.
The good and bad scenarios are, therefore, both largely within the margin of error – and all are pretty lousy at that (albeit better than previously expected). Regardless of which proves right, this is shaping up to be another difficult year for economic growth: one that leaves us all feeling a bit worse off.
Perhaps the more disputed question, then, is another raised by EY today: what might happen to interest rates once they peak?
There is growing speculation that the Bank of England, which predicts the rate of inflation will fall below 4 per cent by the end of the year, might start bringing the base rate down as soon as it thinks it has the scope to do so. While EY expects one more interest rate hike when the Monetary Policy Committee next meets in May, taking the base rate to 4.5 per cent, the consultancy group also expects the BoE to ‘begin cutting interest rates at the turn of 2023 and 2024’.
It reasons that the Bank will soon turn its focus towards the impact rates are having on the cost of living crisis, as well as a looming drop in house prices. EY predicts house prices will fall by 10 per cent over the next two years, largely driven by the impact of rising rates on mortgages.
EY’s predictions are not out of kilter with the market expectation, which thinks the base rate will peak around 4.5 per cent and then start falling, though perhaps at a slightly slower rate than EY suggests. Given the dovish nature of the Bank, which was so hesitant to raise rates even when inflation was soaring, no doubt there will be at least some support within the MPC to drop rates again.
But there are risks to this strategy, as Ross Clark has previously laid out here. In the past few months, the landmines created by ultra-low interest rates started to be uncovered, and the risk of creating such circumstances again should be part of the Bank’s decision-making.
Then there is the question of credibility. There may be pressure to drop the base rate once the Bank is able to do so – but when exactly this moment comes is hard to say. The Bank lost so much of its credibility by failing to acknowledge inflation was surging back in 2021, and it’s not obvious yet that it has rebuilt its reputation. A drop in the base rate when inflation isn’t even back down to target would be a serious test of market confidence.
Furthermore, anyone who did want to make the case that rates should stay roughly where they are would have historical data to back it up. Today’s rate, while painfully high compared to the last decade, is only just creeping up to the very low end of a normal rate compared to previous decades.
Ushering back in a new era of cheap money is by no means a requirement, but would be a choice: a tempting one at that, given how addicted to mass spending everyone has become. But one that, as we’ve learned, has serious repercussions.
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