Inflation and interest rate forecast: will interest rates fall once inflation has peaked?
Many are watching interest rate predictions and inflation forecasts to see what might happen next. The US Federal Reserve’s interest rate actions set the tone for other economies. The Fed will only change direction once inflation is under control.
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The reversal in the interest rate cycle has been a key swing factor in 2022. It has determined the direction of financial markets and which sectors have done well. It is perhaps little wonder that investors are gripped by every statement from the Federal Reserve as they wait to see whether it might change course.
The Federal Reserve has been very clear about its position on inflation
It is prioritising beating inflation over any concerns about the US economy falling into recession. Fed Chair Jerome Powell said in August: “Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labour market conditions that benefit all. The burdens of high inflation fall heaviest on those who are least able to bear them.”
Most other developed markets are following the US. In November, The Bank of England raised the UK base rate by 75bps to 3% the day after a Federal Reserve interest rate increase of the same amount. The European Central Bank (ECB) also raised rates by 75bps at the end of October, bringing rates to 1.5%. Many Latin American countries had already raised rates, with their central banks well-versed in the problems of tackling high inflation.
The only major countries taking an alternative path are China, where monetary policy is loosening and Japan. In both cases inflationary pressures are minimal, largely imported from outside and allow their central banks more leeway.
The only way the Federal Reserve is going to change direction is if inflation looks to be comprehensively beaten
The Fed has made it clear that employment is central to its decision-making. And here the stats are bad, (or good, depending on who is looking at it). Jobs growth has remained very strong in the US, too strong for the Federal Reserve to consider a shift.
In November, Oxford Economics said in response to the last US jobs report: “Signs of cooling in the labour market did appear, as the unemployment rate rose and the payroll increase, while stronger than expected in October, downshifted from the gains in previous months. But wage increases continued to exceed expectations and sustain pressure on employers to raise prices.”
The Federal Reserve will also be looking at the housing market for signs of weakness. The market is cooling as higher mortgage rates deter potential buyers. In July, the S&P Case-Shiller index, which measures house prices in 20 US cities, dropped 0.44%, its first monthly decline in a decade.
To date, this has not been materially reflected in inflation figures, but growth is slowing – inflation peaked at 9.1% in June, but was 8.5% in July, 8.3% in August, 8.2% in September and 7.7% in October. However, a change in direction from the US central bank still looks some way off.
Inflationary pressures are weaker in the UK and Europe than the US with lower economic growth and less pressure on wages
In the UK, food, transport and energy prices have been the biggest contributing factors to inflation. A weak pound sterling is also pushing prices higher, as the cost of imported goods rises. However, the Bank of England’s November interest rate forecast suggests less rapid and extensive movement than in the US. Its inflation forecast is for a fall to start from the middle of next year with inflation back at the target rate of 2% within two years.
While some economists suggest that inflationary pressures are less entrenched in Europe – there were not the same government spending packages, for example – the region has been more vulnerable to the Ukrainian crisis and its impact on energy prices. High energy prices have spread through the economy, pushing up costs for businesses, which in turn, have pushed up prices for consumers. Nevertheless, the ECB interest rate prediction at the end of October was for rates to peak at 3% next year.
Interest rate predictions – will they start to fall once inflation has peaked?
Or will they just stop rising as fast? Central banks recognise the damage wrought by inflation and are likely to err on the side of caution. Investors shouldn’t expect an immediate reversal in rates even if the inflation cycle does start to turn. The world’s inflation problem isn’t over yet – and rising rates are likely to persist into 2023.
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