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Are Interest Rate cuts coming?

Why are interest rates sky-high?

Interest rates play a crucial role in shaping an economy. They impact borrowing costs, savings, and overall economic activity.

Photo: Bank of England

They were increased 14 consecutive times over the last 24 months in attempts to control inflation, which hit double digits in August 2022 for the first time since 1982.

This was a result of increased costs caused by exogenous shocks, such as the Russia-Ukraine conflict and gas shortages affecting supply chains.

These issues have since subsided, and inflation has also come under control. We have entered a period of more controlled, lower inflation, as the CPI index has measured inflation at 3.4%, suggesting that it would be logical to expect interest rates to fall soon.

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Considering that the UK entered a “technical recession” – 2 consecutive quarters of negative growth in GDP at the end of 2023 – the need for cutting interest rates has heightened.

This is because it is difficult for economies to exit a recession without the spending power that lower interest rates provide.

To unleash spending, interest rate cuts must be made to boost the borrowing power of consumers, whilst also leaving more to spend for consumers who have tracker mortgages and contributing to a positive wealth effect for homeowners, which will be discussed later.

Central Banks

Despite good progress, the Bank of England is still above its target inflation rate of 2%, meaning that we may not see interest rates cuts until the Bank of England sees suitable progress towards this.

This could take until early 2025, as historically the “last mile” of inflation seems to be the hardest to reduce.

The Bank of England have indicated that they do not require inflation to hit 2% before they cut rates, and in my opinion are likely to be heavily influenced by how quickly inflation can drop below 3% rather than 2%, as changes in interest rates tend to take time to filter through the economy and take full effect.

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Additionally, the UK has shown a strong correlation between its interest rate decisions and those of the Federal Reserve, suggesting that a Fed decision later this year could also prompt UK rate cuts.

However, promising signs lie ahead, and we saw the first time that no member of the Monetary Policy Committee at the BoE voted to increase interest rates since 2021, indicating that we could see rate cuts coming soon.

Despite this, I would stress that we are likely to see rates remain at this rate for 3 months regardless of inflation, as 8 members of the MPC voted to do so in March, and this is unlikely to change in a short period of time.

Impact of a decrease in rates

If interest rates decrease, one area we may see a major impact could be in housing, as monthly repayments would reduce for mortgages with tracker interest rates and people who are hoping to purchase a property.

The latter may positively influence house prices, as the lower monthly repayments may increase demand for properties, and therefore stimulate growth in the house prices, contributing to the positive wealth effect mentioned earlier.

The flip side is that they can also impact savers who rely on interest income, which could damage an economy where there are many people relying on their savings to survive, i.e. pensioners, with over 65s making up 18% of the UK’s population.

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The delicate balance between stimulating economic activity and maintaining financial stability remains a challenge for central banks.

Final Verdict

If the Bank of England were to follow the Federal Reserve, I believe that we could see a rate cut at the beginning of Q3 2024.

This is likely in my eyes, as the US and the UK are in very similar positions in terms of inflation, and so any move by the Fed is likely to spark a domino effect in Europe. However, this is highly contingent on whether inflation decreases below 3% in the UK.

Any change in interest rates has to be justified by changes in inflation, and if there is no change, the Fed are unlikely to have any influence in the UK.

In the next 24 months, I believe that interest rates will fall to 5% in the next 3-6 months, where they are likely to stay for a few months to stabilize the market.

Subsequently, I anticipate a gradual decrease by increments of 0.5%, with each new rate holding steady for several months to allow for economic adjustment.

I believe that the era of low interest rates that was observed after the Global Financial Crisis will not be seen again in the next decade, and that even in 5 years’ time, the interest rates will likely be at around 2-3%.

To get in contact with feedback on this article please email us at publishing@krugmaninsights.com

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