Commentary by Shaan Raithatha, economist, Vanguard UK
Earlier this month, the Bank of England’s Monetary Policy Committee (MPC) met to discuss the outlook for the UK economy and to decide the appropriate stance for monetary policy. Despite concerns about the Delta Covid-19 variant, the economy has continued to make progress in recent months and underlying inflationary pressures are building.
These recent developments have prompted some members of the MPC to judge that the necessary conditions to begin tightening monetary policy have now been met. Indeed, the UK central bank signalled in its August Monetary Policy Report that if the economy evolves in line with its baseline forecasts, some modest tightening will be required over the next three years1.
That all sounds quite hawkish. However, we think the pace of increases will likely be very gradual, even though we think the Bank of England will start to raise interest rates at some point in the next year or so. This is partly due to a recent change in the way the MPC plans to unwind its quantitative easing (QE) programme, which involves buying government bonds and other securities to lower long-term interest rates.
In June 2018, the Bank of England stated that it would only begin unwinding its stock of QE assets when its main policy rate, the Bank Rate, reached 1.5%. But earlier this month, it changed that guidance. It will now stop reinvesting maturing assets when the Bank Rate (currently 0.1%) reaches 0.5% and it will actively begin selling down its QE asset portfolio when it reaches 1%.
As a consequence, the bar for raising benchmark interest rates above 0.5%, and above 1%, is now higher as QE will also start to unwind.
In our view, and as we have discussed before, the shrinking of the Bank of England’s balance sheet is expected to exert upward pressure on government bond yields and tighten financial conditions.
In our central scenario, we expect the bank to raise interest rates to 0.25% at some point in the second half of 2022 and then to hike them just once more, to 0.50%, by the end of 2023.
So, although the Bank of England has now indicated that it will be ready to start increasing interest rates soon, we believe that the path of normalisation will remain very gradual.
A low interest rate environment over the medium-to-long-term is one factor that underpins Vanguard’s view that asset class returns will be relatively subdued over the next decade. In navigating such a challenging financial market environment, it is therefore important for investors to be realistic about their return expectations and to keep investment costs to a minimum.
1 See the Bank of England’s August 2021 ‘Monetary Policy Report’.
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