BOE Highlights Midpoint in Delayed Rate Squeeze: Mike Dolan, Reuters

By Mike Dolan

LONDON – The Bank of England believes that the UK economy has only experienced about half of the impact from a nearly two-year-long interest rate increase, and market participants are skeptical that the central bank will allow it to implement the full effect.

The substantial five-percentage-point rate hike cycle that commenced in late 2021 may have concluded, but its effect on household demand and overall economic activity could potentially double from this point onward, according to the BoE’s own assessments.

This projection assumes the Bank maintains current rates for an extended period, a strategy referred to by chief economist Huw Pill as the “Table Mountain” approach.

However, there are significant doubts regarding whether the already struggling British consumer and stagnant economy can withstand the full impact of the measures already in place. As a result, markets are betting that the central bank will have to reverse course and implement rate cuts within nine months.

If this speculation holds true, it would mean that the time spent at the peak of interest rates would be less than half of the period taken to reach that peak, with possible rate cuts occurring as much as six months before the Bank feels the maximum impact of its current policies.

The BoE’s comprehensive Monetary Policy Report, issued alongside its decision to keep policy rates steady at 5.25% on Thursday, evaluated the lag effect of credit tightening on household finances.

“Bank staff estimate that more than half of the impact on GDP is still to materialize,” it indicated, projecting it could take until 2025 for the full GDP impact to be realized—based on historical trends, anticipated mortgage and loan refinancing, and acknowledging “significant uncertainty.”

In reaching this conclusion, the report primarily highlights consumer spending, which it estimates accounts for about 60% of GDP.

The BoE offsets the negative effects of increased mortgage costs by considering the rise in savings income—where roughly 80% of homeowners have fixed-rate mortgages of two to five years. This situation delays the impact on consumers.

Interestingly, the report notes that the overall effect of rising interest rates on aggregate income remains positive, given that approximately £1.7 trillion in household deposits outweighs £1.5 trillion in outstanding mortgages.

However, this benefit is concentrated among wealthier households, which tend to spend less of their additional income compared to those who are less affluent and more indebted, effectively neutralizing the positive net effect on the economy.

Additional factors affecting consumption include reduced home values and savings in financial securities, alongside declines in housing and business investment due to higher rents stemming from increased mortgage refinancing for buy-to-let landlords.

Consequently, the BoE anticipates that the repercussions from previous rate changes will “grow over time,” even if immediate one-off quarterly impacts have peaked.

The central mandate of the Bank is to bring inflation back to its 2% target, and it recently increased its inflation projections. The Bank does not expect to reach its goal in full until late 2025.

Markets, however, are betting that the second phase of the current interest rate crunch and the downward trend of inflation will compel the Bank to cut rates as early as next year, assuming that there is steady moderation in wage growth beyond the upcoming Spring wage round.

Some analysts express concerns about the possibility of a “ketchup bottle” effect, where a seemingly slow, delayed impact suddenly manifests all at once.

Economist Modupe Adegbembo from AXA Investment Managers anticipates two quarter-point cuts in August and November, bringing rates down to 4.75% by the end of 2024. Adegbembo cautions, however, that “there is a risk the BoE could be forced to reverse rates earlier and more aggressively if the growth outlook worsens… particularly since the pass-through from rates was slower than expected on the way up.”

On the other hand, little has been predictable in the post-pandemic economic cycle. Regardless of the gradual impact on growth and consumption, unexpected inflation developments could significantly alter the current market outlook.

“Although rate cuts are now being expected in the latter half of 2024, investors should keep in mind that the outlook remains unpredictable—a plateau obscured in fog could very well be hiding Mount Everest,” commented Andy Burgess from Insight Investment.

The views expressed here are those of the author.