Recession ahead for the UK
All eyes have been on the Bank of England this week as it shocked the markets with a larger than expected interest rate increase. Panic has ensued in the media, with much talk of when a recession will appear rather than if one will happen.
The Bank of England raised interest rates by 0.5%, rather than by 0.25%, taking them up to 5%, their highest level since 2008. Whilst the Federal Reserve and ECB are expected to raise rates twice more this year, financial markets are pricing in another four moves for the MPC to reach a peak of 6%. This is very different from last year, when markets mistakenly thought that interest rates need only rise to 4.5%.
The MPC clearly explained its reasoning: “that the second-round effects in domestic price and wage developments generated by external cost shocks are likely to take longer to unwind than they did to emerge. There has been significant upside news in recent data that indicates more persistence in the inflation process, against the background of a tight labour market and continued resilience in demand.”
‘Significant upside news’ is a reference to the poor inflation report for May on the back of last week’s alarming wages data. The headline CPI was unchanged at 8.7% a year, the three month annualised rate is over 8%, whilst the core rate excluding food and energy increased to 7.1% from 6.8% in April, so its highest level since 1992. There are growing signs of domestically generated inflation – the ONS referred to airfares and live music events but also second-hand cars whilst many parts of the services sector remain a concern. It is no surprise against this background that market-based inflation expectations have jumped over the past month to 4% – double the Bank’s target.
Obviously, there is a lot of political criticism of the Bank for being too slow, especially after it admitted that its forecasting models were not working well. However, the economic debate is moving on towards how effective such monetary tightening will be. The UK is facing a series of headwinds from a stronger level of sterling and higher UK gilt yields on top of the rise in the tax burden and pressures on household incomes. The effects are already filtering through a weaker manufacturing sector and a poor housing market, with the media making much of the forthcoming pain for any household who needs to take out a new two-year fixed mortgage rate, above 6.2% for the first time since December. 10 months ago the 2 year bond yield was only about 2%.
ECB and Fed officials are also concerned about the balance of growth and inflation in their economies, but the situation is far less alarming. In the USA, another small interest rate move should be expected in July. Christopher Waller said “inflation is just not moving and that’s going to require, probably, some more tightening to try to get that going down”. The economy was “still ripping along for the most part”. Austan Goolsbee said he views the pausing of rates as a “reconnaissance mission before charging up the hill another time”. US data will encourage the Fed to act next month. Despite much higher mortgage rates, homebuilders’ confidence index has rebounded strongly in the first half of 2023. Housing starts reached their highest since April last year, and before that 2006.
The debate about where next for the ECB was evident in a series of speeches. Francois Villeneuve considered that “we have done most of the path…. and any additional increases will depend on the inflation data observed — everything in its own time, and every decision in its time.” However, others feel that much more needs to be done. Isabel Schnabel warned once again that the eurozone’s incredibly strong labour market ran the risk of a wage-price spiral akin to that seen in the 1970s, whilst Joachim Nagel argued that some central banks in the past had given up too early in the fight against inflation and it was his “intention that we should really prevent this” from happening in the eurozone. Hawks will also point towards the growing calls from prominent state media and top government advisers in China, such an important destination for European exports, for further economic stimulus. On balance, markets are pricing in ECB moves in July and September.
The UK faces a difficult environment, domestically and externally. Can it avoid recession? It is worth emphasising that monetary policy works with famously long and unpredictable lags. The impact of higher interest rates has often been compared to pulling a brick on a rubber band. A lot of effort results in no change until suddenly the brick flies quickly towards you. Business surveys and leading indicators in the UK and all the major economies will be examined even more carefully in coming weeks.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.76 4.01 3.77
UK 5.13 4.62 4.42
Germany 3.24 2.64 2.49
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making