Inflation is coming down globally – Will interest rates fall faster than experts predict?
When Friedrich Hayek accepted his Nobel Prize for Economics in 1974, he made a very honest admission. Not only were economists unsure about their prediction, but their tendency to present their findings with the certainty of the language of science was misleading and may have a deplorable effect. I have used this quote in my blogs before and will use it again because it reminds me of how right he was.
The Bank of England (BOE) has regularly failed to meet its inflation forecasts and has been consistently wrong since the start of the pandemic. Most experts predicted inflation to fall by over 1% in May, and it remained unchanged. This led to massive panic in the financial markets, and interest rates increased to their highest in over 15 years. Markets predicted that BOE's base rate would have to reach 6.5% as inflation had embedded itself in the British economy.
The following month in June, most experts predicted a 0.5% fall in inflation, which almost fell by 1%. This led to markets re-forecasting BOE's base rate to stabilize at 5.5%, meaning that mortgage interest rates started to decrease. So, if this is how good we are predicting month-on-month, what chances have we got at forecasting for two, three or five years ahead? The graph below shows how often forecasts have been wrong in the last 18 months; experts have only been right on six occasions.
Focus on the global trends:
One of the parameters that could help gauge where interest rates and inflation may end up is looking at what is happening abroad. Since the start of the pandemic, the Western world has followed every trend. From low-interest rates and low inflation at the beginning of the pandemic to exponential house price growth and higher inflation and higher interest rates for the last year or so. US and Europe have been better at managing most shocks earlier than the UK, but the UK has eventually caught up near most of its European neighbours and transatlantic partners.
Inflation abroad is slowly ticking down, and markets have started to price in relatively low-interest rates again. US inflation has fallen to 3%. The trend in Europe may be a little mixed, but it has been positive overall; Spain's inflation rate is now down to 1.9%, a spectacular fall from 11% a year ago. And the UK had a promising drop in its inflation figures last month to 7.9%. As the graph below highlights, inflation in the UK is on a downward trend.
Although much higher than the US and most of the Eurozone, we will see a significant drop in inflation figures for July as the energy price drop starts to reflect in people's bills from 1st July. Expect July's figures to be below 7%, which will mark another important step towards the downward trend of inflation coming down in the UK.
In response, investors are increasing their bets that central banks will soon be cutting rates and beginning to rotate back into the interest rate-sensitive sector. UK ten-year yields are just over 4%, and US ten-year Treasuries are 3.75%. That is towards the lower end of the spectrum, consistent with around 2% to 3% inflation.
Low growth forecast for the UK:
The IMF (International Monitory Fund) forecasts that the UK will be one of the slowest growing economies in the G7; high interest over a longer period could stifle business investment which is much needed.
Although the graph below highlights that the UK has seen growth in business investment since the start of the year, the breakdown of investment data from Q1 analyzed by Pantheon Economics suggests that investment was artificially boosted by businesses bringing forward planned spending to take advantage of the government's super-deduction policy. The super deduction allows companies to take off 130% of the value of certain investments from their corporation tax liabilities which finished in March; however, the graph below shows that business investment over the next couple of years is set to fall off a cliff by 2025.
If business investment, as forecast by Pantheon Economics, were to fall off a cliff by their estimates -15%- that would significantly impact growth and the labour market. If businesses are not investing, growth will be limited, making it harder for them to sustain the current investment rate, forcing companies to make efficiencies, which could translate into rising unemployment.
The BOE forecasts that unemployment could reach 5.25% based on their projections if interest rates were to reach 6%. If unemployment were to increase, it would significantly decrease people's consumption capacity, meaning that people would buy less and spend less. There could be a risk of negative inflation.
Negative inflation is not a threat just yet, but if rates remain this high for the next couple of years, then negative inflation is a real threat meaning the BOE will have no option but to start cutting rates rapidly as they did during the pandemic. If inflation is too low or negative, some people may put off spending as they expect prices to fall. Although lower prices sound like a good thing, if everybody reduced their spending, companies could fail, and people might lose their job, something that the BOE will be keen to avoid after the last couple of years.
It is uncertain what will happen with interest rates in the future. However, there is a strong likelihood that rates will begin to decrease starting in the second quarter of 2024 and continue to decline gradually until they reach approximately 3% or slightly lower by the second quarter of 2026. As inflation decreases rapidly, this should indicate a quick end to any further rate increases.