Rob Evans, senior portfolio manager at CCLA Investment Management, takes the Table Mountain path in this partner content article.
With the welcome news that inflation appears to be finally on the way down, discussion surrounding when central banks will call an end to their rapid tightening cycles has intensified, with many policy makers indicating that we are actually at the peak in this cycle.
‘Higher for longer’ has become the new catchphrase, with Huw Pill, the Bank of England’s (BoE) chief economist, likening the path for interest rates to famous mountains.
The first option, he said, is the Matterhorn model. Much like the jagged 14,690ft mountain in the Alps, rates rise sharply and fall just as swiftly.
The second option would look more like Table Mountain in South Africa. In this scenario, rates would not rise as high, but would stay elevated for longer. Table Mountain is much lower than the Matterhorn (just 3,560ft), but its peak is a flat plateau nearly two miles wide. Pill’s preference is the Table Mountain model.
Table Mountain. Photo: Shutterstock.
In this article I will look to explain why we also subscribe to this Table Mountain path, before asking what could potentially derail this opinion and the subsequent impacts on the returns offered by money market funds.
The main determinant of the interest rate path is, of course, the outlook for inflation. For months the Consumer Prices Index (CPI) measure of inflation seems to have been consistently surprising markets to the upside, with the economy experiencing the dangerous combination of core and wage inflation.
However, the August reading represented the third consecutive drop in the headline rate and it’s this release which was widely heralded as the main reason the BoE held interest rates at their subsequent meeting last month.
September’s inflation data saw CPI unchanged at 6.7%. A rise in petrol prices versus a drop in the same period in 2022 was the main source of upward pressure. However, this was offset by a drop in food prices. Core inflation, which excludes volatile food and energy prices, fell, while services inflation moved upwards but remained below the BoE’s forecast. However, the evidence of an easing in broader core pressures will be welcomed by the BoE.
Looking ahead, we expect headline inflation to gradually ease over the rest of 2023. Strong base effects in the energy component of the computation are still to come into play in October. Separately, we also have further scope for supermarkets passing on the reduction in food prices to their customers.
Since the pandemic, another key economic theme has been the resilience of the labour market and strength of pay growth, both of which point to inflation persistence. Over the course of the year, it’s impact on inflation has been one of the main concerns that the BoE has cited in driving their interest rate decisions.
The unemployment data release for August was delayed, but in July the rate increased a little ‒ to 4.3% ‒ in the three months to July (this was from 4.2% previously and 3.7% a year earlier). While wage growth remains very strong, there are now tentative signs that it may be cooling on an underlying basis and with labour demand easing, wage growth tends to follow, albeit with a lag.
On face value, the key drivers highlighted by the BoE for the interest rate rises we have seen over the course of this year, inflation and wages, do appear to be softening. So why do we think the Official Bank Rate (OBR) will remain higher for longer?
Our view is that these indicators are not likely to fall quickly enough, over the course of the next year, to allow the BoE to claim they have returned inflation to their 2% target sustainably. Persistently strong, albeit slowly falling, pay growth is likely to keep core inflation elevated, which should slow the descent in headline inflation.
Meanwhile, with a high headline number, this is still likely to lead to second round inflation effects, even though the value is slowly declining – think how many personal contracts you have linked to CPI! Therefore, we believe, it is unlikely that the CPI measure returns to the BoE’s 2% target until the first half of 2025.
This puts the BoE in a very difficult position. It needs to bring inflation down quickly, but it also needs to be careful not to push the economy into a deep recession. We agree that its best way of achieving this is to follow the Table Mountain, ‘higher for longer’, strategy. The decision to keep rates on hold in September was a reflection of this balancing act.
The Bank of England is in a difficult position. Photo: Shutterstock
What could lead to the BoE changing this view?
The BoE’s guidance continues to suggest more rate hikes could yet come if signs of greater inflationary resilience emerge. It will continue to closely monitor indications of persistent inflationary pressures and the performance of the economy, including, crucially, the tightness of labour market conditions and services price inflation.
Earlier this month, the International Monetary Fund predicted that the BoE would need to further increase interest rates as it faces higher inflation than its G7 peers. In their press conference after the release of their six-monthly World Economic Outlook, their chief economist said that rates may need to rise another quarter-point above the current 5.25%, as he warned of “quite persistent” levels of inflation. Other factors such as the recent upward trend in petrol prices will also keep the pressure on headline inflation.
Another consideration for the BoE will be the actions of rate setters in the US and how their decisions could result in the UK importing inflation, thanks to changes in the value of the Pound.
On the other hand, there are several indicators which may lead to the BoE quickly dropping its ‘higher for longer’ view. Interest rates are widely regarded now to be in restrictive territory. These higher rates will result in a 1.4% drag on the UK’s GDP level through housing-related channels by the fourth quarter of 2024, according to Goldman Sachs.
Meanwhile, Dr Swati Dhingra, a renowned dove on the BoE’s rate setting committee, gave an interview to the BBC earlier this month which was cautious about the UK’s outlook, saying that the full impact of rate rises hadn’t yet been absorbed into the economy. She said: “The economy’s already flatlined. And we think only about 20% or 25% of the impact of the interest rate hikes have been fed through to the economy. So, I think that there’s also this worry that that might mean that we’re going to have to pay a higher cost than we should be paying.”
With the latest GDP data indicating that growth is now on track to fall below the BoE’s projection for the third quarter of this year, we think support for the rate setting committee for the continuation of rate increases will fade. As Dr Dhingra points out, with less than a third of the effects of the rates rises over the last two years being felt by the wider economy it will not be surprising if the fall in growth accelerates. Should that occur, calls to cut rates will undoubtedly grow and we have seen in recent months just how quickly interest rate expectations can, and do, change.
How will this impact the returns offered by money market funds?
Money market fund yields are inextricably linked to the current interest rate environment as well as the expectations for future rate movements. Over the past two months the expectations for the peak in interest rates has moved lower by about a percentage point; as a result, the interest rate curve has flattened and longer-dated investments are no longer yielding well in excess of 6%.
This, combined with the fact that we see limited potential for another increase in the OBR, means we expect yields on money market funds to settle broadly around today’s level. However, with returns on money market funds still well above 5%, we expect rates to remain there for an extended period.
For more information and further updates, please see our website www.ccla.co.uk/insights. For regular online briefings, please see www.ccla.co.uk/events.
