After a peak in UK interest rates, what’s next?

Key takeaways

• The BoE’s monetary policy cycle has now likely peaked in response to slower UK inflation. We do not expect a first interest rate cut before June 2024
• The UK should avoid recession this year, but a less flexible labour market makes the economy more vulnerable to shocks
• There is margin for new fiscal spending in the 22 November budget to boost growth. A potential Labour Party win at the next general election is unlikely to see major macroeconomic policy changes, but may see higher taxes to fund investments in public services
• While the FTSE 100 is weighted to defensive stocks, we retain a neutral view on UK equities. We see sterling staying weak against the euro and US dollar through the rest of 2023.

UK economic growth is weak, but the inflation outlook has finally started to improve. This combination suggests that interest rates have peaked and we expect the Bank of England (BoE) to leave rates unchanged for a second consecutive meeting when its monetary policy committee next reports on 2 November.

The end of an unusual hiking cycle with a peak policy rate of 5.25% is still a very restrictive monetary policy, as it is the highest rate level since the global financial crisis of 2008. Nevertheless, it is a more benign outcome than looked likely just a couple of months ago. At that time, a series of high inflation readings meant money markets anticipated policy rates peaking at 6.50% (see chart 1). That was even higher than expectations during the sharp market sell-off that followed the ‘mini-budget’ of the short-lived Liz Truss government in September 2022.

While the UK’s 6.7% inflation in September 2023 was higher than most other advanced economies, it has fallen from above 11% a year ago. It is set to fall even further in October, thanks to a ‘base effect’ of comparing high rates with 12 months earlier, and the lowering of a cap on household energy bills.

While the UK economy should narrowly avoid recession in 2023, we still only expect real gross domestic product (GDP) growth of just 0.2% for the full year. High interest rates will be a drag on growth over time, even if the lags are likely to be longer this time around given the notable increase in fixed-rate mortgages since the financial crisis.

Against a backdrop of anaemic growth and falling inflation in the months to come, we believe that the BoE will switch from tightening to loosening policy by mid-2024. We think the first rate cut may come next June, which is broadly consistent with money markets’ expectations.

Labour pressures

With access to European labour now reduced post-Brexit, the UK economy has become less flexible and more sensitive to shocks, complicating its post-Covid recovery. Issues in the labour market have been both a cause and effect of high inflation, as workers struggle to recover some purchasing power by negotiating wage rises. Labour market shortages have also constrained growth, with a record 2.6 million people now out of work suffering long-term health issues. This trend may be related to Covid complications and long waiting lists for treatment.

However, fears that rising wages would translate into spiralling prices have diminished. The unemployment rate in the UK has risen from a low of 3.5% in 2022 to 4.3% currently, and job vacancies have been steadily declining for the last 15 months. The labour market overheating of last year appears to be behind us, and further rebalancing is likely, as demand in the economy cools further. While UK wage growth has been strong so far, forward-looking indicators such as the REC survey point to a substantial slowdown in the coming months.