Financial markets are pricing in a series of further interest rate increases from the Bank of England in the next year amid accelerating prices. The annual rate of inflation in the United Kingdom was 7% in March and is set to breach 8% in April as the effect of the energy price cap rise feeds through.

The table below shows how financial markets expect the UK central bank’s main policy rate, the Bank Rate, to rise by about 1.75 percentage points over the next year – from 0.75% today to around 2.50% by March 2023.

Market expectations for UK interest rates

Notes: Bank Rate as implied by the GBP Overnight Index Swap (OIS) forward curve. Source: Bloomberg as at 25 April 2022.

The Bank of England will hope that its efforts to clamp down on inflation will not come at too great a cost for the economy. This optimistic scenario – where inflation drifts back down towards the central bank’s 2% target and the economy continues to grow close to potential – is known in economist-speak as a ‘soft landing’.

However, given the economy is already struggling, a significant tightening in monetary policy would risk a ‘hard landing’ instead. This is where activity slows down to well below potential and raises the spectre of recession.

Indeed, recent data paints a pessimistic picture for UK household consumption spending. Higher energy and food prices, coupled with increased taxes, has caused retail sales to stall in recent months. And consumer sentiment has taken an additional hit from the war in Ukraine, as the chart below shows.

Growing pessimism

Source: GfK Consumer Confidence Barometer as at 22 April 2022.

Although these shocks are partially softened by the savings many households were able to accumulate during the pandemic, there is now a real risk that consumption will suffer an outright decline in the coming quarters.

The Bank of England finds itself in a tricky position, playing a fine balancing act between controlling inflation whilst limiting the harm done to the economy. In our view, should the central bank follow the path currently priced in by financial markets, the risk of choking off economic activity and inducing a recession is high. Particularly given continued geopolitical uncertainty, an expected tightening in monetary policy in many other economies and a slowdown in China amid renewed lockdowns.

More likely, we think, is that the Bank of England will pause its hiking cycle later in the year to allow the economy space to breathe. We think that it will feel more emboldened to do this if our baseline inflation forecast charted below proves correct, with inflation falling sharply back towards target after peaking in the final quarter of this year.

Better news

Source: Office for National Statistics, Vanguard forecasts as at 27 April 22.

All in all, this implies a slightly shallower path for UK interest rate rises than currently assumed by the market. In such an uncertain macroeconomic environment, it would not be surprising if we experienced bouts of volatility in financial markets in the months ahead. For long-term investors, it will be important to remain disciplined, keep your strategic goals in mind and stay the course.