Sitting at 1.75% at the time of writing, the Bank of England’s interest rate is expected by financial markets to more than double by May 2023. Soaring global energy prices will continue to be ruinous to the economy, causing the Ofgem energy price cap to almost triple to £5,816 by April next year, according to Citibank’s forecast. This tariff is not exaggerated – Cornwall Insight, leading energy researchers, predict an even higher cap. These sharply rising energy prices are estimated by Citi to lead to 18.6% inflation in January 2023, and Goldman Sachs predicts a more foreboding 22%. To curb inflation, a hike in interest rates is required – but by how much?

Economists offer a moderate outlook, with a consensus among those in the City that rates will reach only 2.5%. But the market itself predicts that the Bank of England will be much more forceful. Recent trading activity of interest rate swaps, which represent financial institutions’ expectations of forward interest rates, indicates traders expect a rise in rates to 4% by May 2023. The UK government bond (or ‘gilt’) market offers a slightly less bleak outlook. The yield on two-year gilts – indicatory of the expected interest rate for the next two years – recently reached almost 3%. Rising two-year yields indicate that the market not only expects, but believes the central bank should increase the interest rate to combat inflation.

Stronger indications emanate from Whitehall. Liz Truss, newly elected Prime Minister, is finalising an upwards of £100Bn package to fix household electricity and gas bills – a stimulus this large implies slower growth, bigger debt, and higher interest rates. Growth predictions were already bleak, the Bank of England expecting GDP to fall to 3.5% for 2022 and contract a further 1.5% in 2023 (see Figure 2). Such forecasts show that the UK is headed for a recession, which will further influence the Bank of England to hike interest rates.

Figure 2: The United Kingdom’s Annual GDP Growth Forecast

The Monetary Policy Committee (MPC), the body within the Bank responsible for setting the cost of borrowing every six weeks, has received intense criticism for its failure to contain inflation within its 2% target. A number of former MPC rate-setters have come forward to criticise the slowness in reacting to inflation, citing complacency, a failure to spot key indicators, quantitative easing, and a too heavy focus on economic growth. The central bank’s reputation is now being questioned by the Government, with Liz Truss pledging to review its mandate to ensure it is ‘tough enough on inflation.’

High inflation, poor growth forecasts, and political pressure on the MPC all support markets’ predictions of high rate increases over the next 12 months. Given these conditions, it is no surprise that official support within the MPC for low rates has vanished. It has increased the rate at 6 consecutive meetings, and these decisions are now made with near-unanimity – 8 of 9 members voting for a 0.75% increase in the August meeting. The flock of former MPC members criticising the body’s slowness have made varying estimation’s of its future rates, between 4–6% being the most common predictions. With rates on the rise and recession around the corner, there is no question that borrowing will be strangled even further.

By Joshua Troup

How High Will Rates Rise?