It’s time to rein in historic interest rate rises

Buckle up – it’s a big week for the world’s economy, one packed with important inflation and jobs data and critical decisions to be taken on the direction of interest rates in the US and the eurozone.

Kicking off the roller-coaster in the US is the Consumer Price Index inflation numbers for May which are published tomorrow – and are expected to show another cooling – followed by Producer Price inflation and retail sales data on Wednesday. 

That’s the same day the Federal Reserve will decide on whether to “pause or skip” another rise in interest rates. All the big bets in the money markets are suggesting the Fed will take a breath and “pause” rates after having raised them ten times in a row since March last year. 

According to a Reuters poll, most Wall Street banks expect the Fed to keep it unchanged at 5.25 per cent, mainly because Fed members will be wanting to assess how well the latest round of penal interest rate rises are squeezing demand before taking action again. 

While that looks like the right decision – as inflation is falling pretty sharply – the Fed looks set to continue with its hawkish tone because of the continuing strength of the jobs market and core inflation still being too high. Just in case the markets are getting too relaxed about the cooling down of the fastest pace on interest rates in 40 years, the Fed is also likely to imply that this pause is merely a skip – and that it will resume raising rates again in July. Further news on the jobs market is published on Thursday.

That’s when all eyes switch to Frankfurt when the European Central Bank meets for its monthly meeting to decide on raising interest rates again. Although the eurozone is now in technical recession and inflation is falling sharply, the ECB is still likely to press ahead with another 0.25 per cent rise in rates to 4 per cent in its fight to curb price rises. 

Christine Lagarde, the ECB’s president, suggested only last week that while core inflation shows “signs of moderation”, it was still too early to call a peak.  

Indeed, Lagarde made it clear in a recent speech in Hanover that the ECB still has some way to go in its attempt to flatten inflation: “That is why we have hiked rates at our fastest pace ever – and we have made clear that we still have ground to cover to bring interest rates to sufficiently restrictive levels.”

She went on: “These hikes are already feeding forcefully into bank lending conditions, including here in Germany. And we know that – having hiked so far and so fast – considerable tightening is still in the pipeline.” Looking back, that was an important point made by Lagarde because one of the great fears of this latest round of rate tightening was the potential impact on the European banking sector. This is because banks earn interest from long-term loans but they fund themselves in the short-term lending markets. Any sudden shock – as we saw earlier this year with the collapse of Silicon Valley Bank and Signature Bank in the US – can catch the banks out because their interest rate risk is mismatched. So far, any fears that this might tip any of Europe’s banks – particularly the smaller ones – have receded. 

After the ECB on Thursday, the spotlight turns to the Bank of England whose Monetary Policy Committee meets on June 22 next week. All the noises emerging from the MPC are also pointing to another increase in the base rate of 0.25 per cent to 4.75 per cent – the highest in 14 years.

And if you look at the future money market rates, there are more rises to come, even though only a few weeks ago they were betting on rates coming down. April’s much higher than expected inflation has unsettled the forecasts with economists and traders now expecting rates to hit 5 per cent over the next few years.  

What the Bank’s MPC will be looking at with a microscope next Thursday is next Wednesday’s inflation figures: core inflation is likely to stay high but tumbling energy prices are expected to show a continued decline. 

Even so, stubbornly high core inflation is behind the latest bout of volatility in the gilts market. And all this uncertainty is prompting investors to demand a higher return for lending to the government, pushing up bond yields back to the levels seen in the gilts market blood-bath during Liz Truss’s brief reign and her clumsy mini-budget. (Truss – and indeed the catastrophe of the Liability Driven Investments market – can’t be blamed this time.)

At closing prices today, the two-year gilt yield is now hovering around 4.6 per cent, having shot up from 3.8 per cent only a few weeks ago. 

And it’s this fear of much higher interest rates to come which is triggering so many banks and other mortgage providers to withdraw current mortgage offers because they are having to reprice their risk. 

What is clear, however, is that the huge spike in interest rates over the 18 months – the base rate has been hiked 12 times since December 2021- is causing pain for homeowners with mortgages and adding to the squeeze on incomes. The economists at Cebr have done the numbers: those homeowners renegotiating their mortgage deals in the next two years will face a hefty £8.7 billion increase in their payments as a direct result of tighter monetary policy.

Cebr also estimates that the 2-year mortgage rate, where the loan to value is 75%, is likely to average 5.1% in 2023 – a doubling of rates for many. 

What’s more, Equifax UK reports that 7.7m out of the 10.7m active mortgages are on fixed-rates and will have to be remortgaged. Worse still, around 367,000 fixed-rate mortgages reach the end of their five-year deals this year. As the average outstanding balance is £170,000, home-owners who switch to variable rates will pay a chunky £300 or so a month in repayments. That’s a serious squeeze. 

Which is why the Bank of England should follow the Fed and go for a pause and a skip in June, also giving those on the ground time to assess how deeply the current squeeze is now affecting demand. What does the Bank have to lose by waiting to see? 

Indeed, the Old Lady got the interest rate cycle utterly wrong on the way up by waiting too long before putting up rates and allowed the money supply to grow out of control through Quantitative Easing. Now the monetary supply is tightening sharply, and energy and commodity prices are falling as supply chains readjust. Some economists now fear deflation. Waiting a month or two before making another hike is the only sensible option – and can’t hurt anyone.

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