Inflation, interest rates and central banks: a financial forecast
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Annual UK inflation over the last 25 years has been 2%. In the previous 25 years it was 8%. As I have written previously (for example here), I believe the last 25 years to have been an anomaly, with inflation moderated by the global increase in the supply of labour provided firstly by the iron curtain coming down in 1989 and secondly by China’s induction to the WTO in 2001. Those positive supply shocks were a one-off; there is no prospect of them being repeated over the next two to three decades.
I feel though that I really ought to put some money where my mouth is and make an actual prediction about what this all means for inflation, policy, and asset returns. I am nervous about doing this, not least because as Niels Bohr, the Nobel laureate in Physics, once said, “Prediction is very difficult, especially if it’s about the future!”
Professor Bohr, however, was clearly unfamiliar with the dark art of forecasting as practised on Wall Street or in The City. Here the rule of thumb is that if you’re going to forecast you must forecast often. That way you can point to the ones that play out while conveniently sweeping the others under a proverbial carpet. Failing that, your forecast should be cunningly hedged along the lines of “there is a real danger of x over the next 18 months” or “there is a 40% likelihood we will see y.” If x or y don’t transpire, you have several options – you can roll the forecast forward; find extenuating circumstances – freak weather, say, or a wildcard, geopolitical event – to explain why things turned out differently; or claim you were right all along and trust no one’s going to recall the exact details of who said what when anyway.
Weathermen and weatherwomen, to my ears at least, have also mastered the dark art of forecasting. Much of their bulletins are taken up with a description of what the weather did earlier in the day in various parts of the country, which obviously requires zero forecasting prowess. When they do finally make a prediction, it tends to be something professionally imprecise along the lines of “there is a 70% probability of scattered showers” or “it will be wet in the north, drier towards the south.”
I plan on saying something a little more precise than this, but hope you’ll indulge me if I first steal a page from the weather forecaster’s almanac and take a moment to describe the financial weather over the last 12 months. In short, it’s been awful. In the year ending October 31st, a benchmark of UK Government bonds was down 25%, while the price of the average FTSE 100 stock was down 20%. Financial markets, to use a technical term, have had a shocker. But why?
2020-21 saw both fiscal and monetary easing which, in a close-to-full-employment economy, led to too much money chasing too few goods and inflation. In 2022, markets started to discount lower government spending and higher interest rates. Central banks, including the Bank of England, were slow to react at first but then sprang into action, rapidly raising base rates. Higher rates increased the yields on financial assets through lower prices – 20% lower for stocks, 25% for bonds. Higher yields were required to make riskier assets competitive with the higher returns now available on cash.
The Bank of England predicts that two years from now inflation will have fallen back to its 2% target. The market, on the other hand, expects inflation over the next decade to be in the region of 3.5%. Because it incorporates the financially incentivised wisdom of the crowd, I’m inclined to go with the market’s consensus forecast.
While base rates offered less than 1% above inflation over the last 25 years, they frequently offered more than 2% in the prior period when inflation was higher. If the market consensus on inflation is correct, we might expect a new normal for inflation of 3-4% and base rates, therefore, of 5-6%. Currently, the base rate is 3% and we can, therefore, expect an adjustment upward. The obvious question is when that will be.
My prediction is that as tighter fiscal and monetary policy kick in, we will see a recession, as the Bank of England forecasts. (The latest figures confirm that the economy shrank by 0.2% in the third quarter.) This will cause the Bank to pause its tightening cycle while it scrutinises the incoming data to inform its next move. The Bank will tell us it is “data dependent”, which is City-speak for “we haven’t the foggiest”. Markets will celebrate this pause with a “relief rally”, which will see stocks and bonds recover the last year’s losses. Asset prices will recover, and growth will pick up.
Positive economic growth and market returns will stop inflation reaching the Bank’s 2% target level — the downturn will not have been severe enough or prolonged enough to sufficiently dent employment. The Bank then will have no choice but to resume its tightening cycle. Which is the point at which we transition to a new normal of 4% inflation and 6% base rates.
For investors, inflation is more of a risk over the medium to long-term than over the short term. This is particularly true for investors in fixed income securities, as rising inflation can put their periodic coupon payments underwater. To compensate for this risk, bonds have historically offered investors a term premium over the base rate of roughly 1%. Therefore, in this new normal environment, bond investors can expect to earn yields of 7%.
Obviously, this new normal will be great for savers, who can now get a competitive return on their savings pots – one that is comfortably above the inflation rate. Unfortunately, the transition is going to be painful. At a 7% yield, the price of existing bonds will be lower than today by a further 25% and the price of both public and private equity will be a lot lower too.
As it unfolds, the higher cash rates and falling bond prices implied by this transition will present a crisis for those who have borrowed short and lent long. UK pension funds’ Liability-Driven Investment programmes (LDIs) are a recent poster child for what can go wrong in such an environment. The Bank of England had to step in and bail them out when the prices of the long bonds that they had borrowed short to lever, fell.
Unfortunately, like other central banks, the BoE has also been in the business of borrowing short to lend long. QE, after all, was specifically a programme whereby central banks injected liquidity into the system by buying bonds. As a result, they own bonds and owe cash. As bond prices fall, and the yield they owe in cash increases, their equity capital bases erode. It is not inconceivable that one or more of them will require a recapitalisation, which will not be popular with taxpayers.
I predict the tide to go out on the period of low inflation and interest rates and that there will be a painful transition over the next two to three years to an era of higher inflation and interest rates. That will be a better place for savers, including bond investors, who will finally be able to get a decent yield on their savings pots, but the journey there will be a difficult one – stock and bond prices will first recover before falling below today’s already depressed levels. Some institutions will be caught out by the receding tide. We can’t say today who that will be – we’ve already seen some LDI programs embarrassed, and we may yet see a central bank in a similar position. At the end of the day, as the investment guru Warren Buffett likes to say, it is only when the tide goes out that we get to see who has been swimming naked.
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