INTEREST RATES
Bank of England talks tough, but holds
Rather than raising interest rates aggressively, as they did in 2022, we think the Monetary Policy Committee (MPC) will keep interest rates on hold this year, at 3.75%, especially if oil prices remain at current levels. However, if energy prices rebound or there are signs of second-round effects emerging, then the Bank will be forced to act.
Holding interest rates steady should help to bring gilt yields down. But the change of Prime Minister and potentially higher borrowing will keep gilt yields persistently high relative to the UK’s peer countries. That will keep the cost of funding in the UK elevated, even if the Bank keeps interest rates on hold.
Will the MPC increase interest rates in 2026?
At the start of this year, we expected the Bank of England (BoE) to cut interest rates twice, with a possible third cut as inflation fell back to 2%. The war in Iran and subsequent jump in energy prices has turned that picture on its head.
However, that doesn’t necessarily mean that the BoE will have to act as it did in 2022 for three key reasons:
Limited energy shock The energy shock this time around is not nearly as big as in 2022. Natural gas prices have risen by 25% compared to a seven-fold rise in 2022. That is unhelpful for the MPC, but it is a small enough rise that many on the committee feel they can look through the initial shock and focus more on the overall economic impact
Already elevated interest rates Interest rates are already at 3.75%, rather than the 0.5% they were at the start of 2022, before the energy crisis. That reduces the need for policy tightening. Monetary policy is already modestly restrictive and so interest rates at their current rate will bear down on inflation even if left where they are. What’s more, gilt yields at around 5% represent a sharp tightening in financial conditions which will weigh on demand regardless of whether the policy rate moves.
Weak economy The economy is much weaker now than going into the previous energy shock. The unemployment rate was below 4% at the start of 2022 and consumer spending was surging after the pandemic. In comparison, an unemployment rate that will peak at 5.3% and tepid consumer spending means second-round effects, where businesses put up prices and wages, are much less likely to occur this time.
These factors don’t rule out rate hikes. After all, the MPC was heavily criticised for not raising interest rates quickly enough in 2022. Inflation expectations are high and will be above target well into 2027. Financial markets are currently pricing in two rate hikes this year. But it does mean any rate hiking cycle is likely to be short and shallow.
OUR FORECAST
We expect interest rates to then be cut three times in 2027 as inflation falls back sharply and the MPC’s focus switches from worrying about inflation to the higher unemployment rate.
Will borrowing costs remain elevated for businesses?
Even if the BoE keeps interest rates on hold this year, gilt yields look set to remain elevated. The UK’s sensitivity to energy prices and sticky inflation means gilt yields, which are the cost of government borrowing and set the cost of borrowing for much of the economy, have risen by more than most other developed country yields.
However, the change of Prime Minister is also adding to the cost of borrowing. Andy Burnham the top contender to replace Prime Minister Starmer. For financial markets this raises the risk that a new government will borrow more or introduce more growth hampering legislation.
Ultimately, the combination of a hawkish MPC and a change in Prime Minister means a higher yield curve, from which private sector debt is priced, that will keep funding costs elevated.
