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22nd May 2023

Market update

As widely expected, both the US Federal Reserve (Fed) and the Bank of England (BoE) raised interest rates by a further 0.25% each. That makes it a dozen successive rate rises from the BoE, bringing the base rate of interest to 4.50%. The rises had very little market impact as both were fully priced into bond and equity markets.

Good news for the UK?

Whilst, in theory, this is good news for savers (if banks passed rate rises on in full), it puts further pressure on borrowers, particularly those of us with fixed rate mortgages coming to an end soon. However, the revised economic forecasts from the Monetary Policy Committee (MPC) were somewhat more upbeat than one might have expected as they no longer believe that the UK will enter recession this year.

The MPC now expects GDP growth for the UK to be flat over the first 6 months of this year, then to grow by 0.9% to the middle of 2024 and 0.7% by mid-2025. The MPC noted that they think “the path of demand is likely to be materially stronger than expected in the February Report, albeit still subdued by historical standards”. So, a weak economy but just about dodging a recession, in their view.

The MPC also expects inflation to start falling from April’s 10.1%, helped by further falls in wholesale energy prices. However, the declines in inflation are expected to be slower than previously forecast, now falling to 5.1% by year end, against a previous estimate of under 4%. They noted “The Committee continues to judge that the risks around the inflation forecast are skewed significantly to the upside, reflecting the possibility that the second-round effects of external cost shocks on inflation in wages and domestic prices may take longer to unwind than they did to emerge”.

In plainer English, the MPC is worried that workers’ demand for higher wages, to protect their standard of living and spending power, will serve to further increase the prices of goods and services. They would prefer for us all, to paraphrase the BoE’s Chief Economist, Huw Pill, to accept that we are poorer and stop seeking pay rises. Not the wisest choice of words in today’s climate, I’m sure. The thinking behind these comments is that if real wages (i.e., wages after inflation) fall sufficiently, then people will be forced to cut back on spending, thus reducing demand. As demand falls, companies should then start cutting prices to try and win back customers.

The Fed’s conundrum

As we’ve discussed before, the Fed faces a similar conundrum with a robust jobs market and inflation which is still too high, albeit falling. The Fed also faces the threat of troubles in the regional banking sector and the looming debt ceiling deadline. For a brief explainer please see Steven’s monthly commentary here.

During the press conference after the rate rise announcement, Fed chair Jerome Powell said that the process of getting inflation down to 2% “has a long way to go and that future decisions will be made meeting by meeting”, adding that the Fed will make an “ongoing assessment about if the policy rate is sufficiently restrictive”. He also said banking conditions had improved since March, though there is still stress within the system.

During Q&A, Powell added that the committee had discussed pausing rate rises. However, that was not for this meeting but noted that they are likely not far off. He also reiterated that the Fed’s assessment is consistent with no rate cuts in 2023.

So, a pause from June’s meeting seems to be on the cards but the mention of no rate cuts this year is at odds with the market which is expecting the Fed to cut rates from June or July, and by 0.75% to 1% by the end of 2023. Who is right could have an impact on bond markets. Markets tend to move the most when there is a big surprise and, because bonds are so highly sensitive to the path of interest rates and inflation, all eyes will continue to be on future announcements from the Central Bank. If the Fed pauses and then holds interest rates at their current level for a period, rather than cutting, we might see some upwards pressure on bond yields (equalling falling prices).

The outlook, therefore, continues to be difficult to navigate. Markets seem to be sanguine over the multiple hurdles that need to be overcome (inflation, path of interest rates, US banking troubles and the US debt ceiling) and any surprises could easily cause further volatility. If interest rate rises take a year to eighteen months to be felt in the real economy, then only the first few rate rises are taking effect and we have quite some way to go until we are out of the woods.

Until next time, stay well.

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