The Bank of England has cut interest rates by 0.25 percentage points to 5%. Interest rates had previously been at a peak of 5.25% for over a year.
The move comes as the outlook for inflation, which measures the rise in the cost of goods and services, has improved. Core inflation, which excludes volatile food and energy prices, peaked at 7.1% in the 12 months to May 2023 and has since halved to 3.5%1. Both the Bank of England and our team of economists expect core inflation to hit the Bank’s 2% target by the second half of 2025.
Meanwhile, after a shallow recession2 in the second half of last year, the UK economy has rebounded. The economy grew by 0.7% in the first quarter compared with the previous quarter and we estimate it will have grown by another 0.7% in the second quarter. This is supported by household incomes now rising at a faster pace than the rate of inflation.
From here on, we anticipate that interest rates will fall only gradually. Interest rates are expected to be at 4.75% by the end of the year and around 3.75% by the end of 2025. This gradual approach is because both services inflation (the prices that consumers pay for services) and wage growth remain elevated and growth is picking up. The last mile in the fight against inflation will be difficult.
As the chart below shows, this view is broadly in line with what financial markets are expecting.
UK interest rates are expected to ease only gradually over the coming quarters
Note: The green line shows financial markets’ interest-rate expectations based on the overnight index swap curve until June 2025 (an overnight index swap is a type of financial contract designed to manage interest-rate risk). The gold diamonds are Vanguard’s forecasts. The grey dotted line shows the average level of Bank Rate (the Bank of England’s main interest rate) between the first quarter of 2010 and the fourth quarter of 2019. Data as at 25 July 2024.
Source: Bloomberg and Vanguard.
The key message is that, despite interest rates finally starting to fall, they will remain fairly high over the medium term. We do not believe we will go back to the experience of the previous decade, when rates averaged close to zero.
This is also reflected in the UK mortgage market, where lenders tend to anticipate interest rate changes in advance when setting mortgage rates. Most two- and five-year fixed mortgage rates remain above 4.5%3 (see chart below).
Average two- and five-year fixed mortgage rates
Source: Bank of England, as at 25 July 2024.
This higher interest-rate environment has important, and encouraging, implications for investors. It puts future returns from bonds4 and shares on a surer footing. We expect UK bonds and global ex-UK bonds to return an average of 4.2-5.2% and 4.4-5.4%, respectively, over the next 10 years for British pound investors5. This compares to a forecast of 0.8-1.8% for both UK and global ex-UK bonds back in the fourth quarter of 2021, which was before interest rates started rising.
Similarly, UK and global ex-UK shares are now expected to return 5.0-7.0% and 4.4-6.4%, respectively over the next decade. This compares to 4.2%-6.2% and 2.5-4.5% before interest rates started rising.
The shift to a higher interest-rate environment is something we’ve highlighted before in our annual outlook for 2024. To keep up to date with our latest macro and market views, read our monthly economic update.
1 As at June 2024, using data from the Office for National Statistics.
2 A recession is typically defined as two consecutive quarters of negative growth.
3 These rates assumes a loan-to-value ratio of 75%. In other words, someone who is borrowing 75% of the value of the home they want to buy.
4 Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.
5 As at 31 May 2024.
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