The Next Steps for Central Banks

Written by Ishkaar Ujoodia , Harry Donovan-Anns and Dinil Wanni Arachchige

Interest Rates Today

Since the 2008 Financial Crisis, central banks' monetary policy has been exceptionally dovish, with interest rates from the Bank of England (BoE) decreasing from a high of 5.7% just before the crisis to a low of 0.1% in March 2020, due to the unprecedented impact of COVID-19 on markets and the economy. Following the pandemic, however, central banks have pivoted to a tighter monetary policy, adopting a hawkish stance in the face of broad-based and persistently high inflation. The BoE most recently increased the base rate by 75bps to 3%, the largest increase seen in over 3 decades, in response to CPI inflation reaching a 40-year high of 10.1% in September.

This year, 2022, has been the transition period between central banks believing that inflation is a transitory, post-pandemic reopening-related phenomenon that will fall away with little intervention, and believing it could become entrenched, leading to runaway inflation expectations and to some degree, threatening financial stability. While all major central banks have been ratcheting base rates of interest up over the last few months, there have been some apparent differences in the pace of hikes and messaging employed by policymakers. Below is a time series representation of some of the most important base interest rates and how they have changed since the start of the year.?

Despite the fact that many authorities have lagged somewhat behind the US Federal Reserve’s aggressive tightening policy, the clearest divergence of policy from their example is that of the European Central Bank, which started raising rates in August some 5 months after the Federal Reserve. Alongside growing fears of a prolonged global recession, the slower tightening of monetary policy has contributed to the steep decline in many currencies relative to the US Dollar, it being the reserve currency of the world to which investors flock in times of crisis. The chart below illustrates the fall in the value of both the Pound and the Euro since the start of the year. The euro has fallen over 11% against the dollar while the sterling is down 15.5%. Interestingly, the pound actually lost value following the BoE’s first 75bps rise – a counterintuitive response from markets – due to the contrast between the Bank’s more dovish forward guidance and what came from the Fed a day prior. While Powell indicated that the peak in rates was likely to be higher than currently priced in money markets, Bailey felt the opposite was true for the UK.

Effects on Pensions, the Private Sector and Housing

To fully appreciate the rise in interest rates, we must consider its effects on the individual and wider economy. It was recorded, in April 2021, that the workplace pension participation rate in the UK was at 79%. With so many dependents on these funds, providing clarity over this tumultuous event seems necessary.

Traditionally, pension funds split their assets among a range of stocks, bonds, commercial real estate and cash. The proportions of each, are usually dependent on how close to retirement you are. This is because as one approaches retirement, there is less time to ride out market shocks and instead the focus will be on the preservation of existing funds. This means low-risk, typically bonds and cash, investment strategies for older pension savers.

Though the concept is simple - when interest rates rise borrowing becomes more expensive and prices of bonds go down. This has the potential to affect asset prices as well as the stability of the businesses that sponsor pension schemes.?Furthermore, at a time of high inflation, 10.1% to be exact, it is probable that pensioners may come under further financial strain.

Despite this, having observed statements from the pensions industry, the general consensus is more positive. The interest rate rise was widely anticipated and reflected in the price of the market; thus, the short-term impacts seem to be insignificant. It must also be considered that over the long run, rising interest rates can increase a bond portfolio’s overall return – this is because money from maturing bonds can be reinvested into new bonds with higher yields. Yet, with the ambiguous impact of the mini-Budget, some pension pots may find themselves worse off.

The housing market has also experienced a considerable slowdown with the steepest fall since February 2021. Interest rates moving to 3% will have unfixed monthly mortgage households paying hundreds of pounds more. While landlords enjoy the climb in rental prices, those who wish to get on the property ladder are struggling. Despite the fall in housing prices of 0.4% last month, mortgage availability has been hit by economic uncertainty and the recent spike in interest rates.?

Therefore, the housing market is anticipated to slow down as rising inflation rates necessitate higher interest rates. Yet empirical data suggests there is still a shortage of homes. There are presently 61% more prospective buyers than the five-year average. In the meantime, there are 37% fewer houses for sale than usual.

With the recession expected to extend till 2024, there is significant pressure on small businesses. Debt fuelled businesses can expect rates on loans to spike, increasing overheads and a burden on cash flow. If this is the case, the ability to attract investors could take a hit and in the worst case stop, both of which small companies cannot afford in the current economic environment. In effect, this would leave businesses to either ride out the market or hedge the product with an agreement with the bank. Ultimately, this may not eliminate risk with suppliers and consumers likely to also be affected by interest rates increasing.

What is the forecast for the years ahead?

The reaction to high inflation levels seen globally has been a necessary one, however, the global economy is now facing a second, possibly larger problem: the threat of recession. It has been reported that the UK is facing its longest downturn in recorded history, expected to last into 2024, with unemployment jumping to 6.5% alongside slumps in GDP. The natural question which arises from this is simple: when will the Bank stop being so hawkish, and what are going to be the consequences of this period of steady hikes?

The first part of this question is incredibly tricky to answer. Countries around the world are in an extremely difficult position, attempting to find the balance between fighting a market meltdown and battling climbing inflation.

In the UK, the outlook for how high the interest rates will rise has been varied following Liz Truss and Kwasi Kwarteng announcing the mini-Budget. The plan of a slow, steady increase in rates was derailed by the mini-Budget sending markets into turmoil and forcing the BoE to step in. As a result of the mess, the Bank has needed to raise interest rates faster, implementing their first 75 basis-point rises on November 3 with current terminal rate predictions topping out at 4-4.5%.

It is thought that these levels of rates should be enough to tackle the problem of inflation, however, it is likely to cause adverse consequences, such as a correction in the property market and mortgages seeing their interest rates increasing heavily. Alongside this, the UK is not only facing demand-pull inflation, but also problems with the supply chain, and soaring energy costs. There is not a lot the BoE can do to combat these, so, it is hard to forecast their next moves. To further amplify the problem, we are seeing an incredibly unclear fiscal strategy from the new government, however, we are set to receive more details on November 17th, which should help us form a clearer forecast for the direction the UK economy is heading.

The consequences of these interest rate hikes are less tricky to decipher. Theoretically, an increase in interest rates will create a reduction in liquidity in markets, and this will cause increased volatility in markets. This strained liquidity is something which is not desirable, and the Fed warns that this, paired with consistently high inflation and structural vulnerabilities in the short-term funding market, are problems which could have unexpected, dangerous consequences on markets and the economy.

All in all, the outlook for central banks’ actions is very unclear at present. They are in a very precarious position and theoretically cannot choose a single path to follow which will not have adverse consequences. It is likely, however, that the BoE and the Fed will both choose not to make a dovish pivot soon, and will instead attempt to control inflation back to its target rate, as this is within both of their mandates, and will ensure they do not lose their credibility. This is very much dependent on the markets, and whether they manage to resist breaking. If the markets do break, and there is a large and widespread fall in spending, disinflationary pressures will force the central banks to turn dovish and cut the interest rates quickly once more.