Throughout December 2023, central banks in both the United States and Europe maintained their main interest rates at current levels for the fourth consecutive month. These rates are of paramount importance, impacting the borrowing and lending activities of banks, and consequently influencing the cost of credit for businesses and households with loans, including mortgages.
The European Central Bank (ECB), the US Federal Reserve, and the UK Bank of England had previously implemented significant interest rate hikes since the beginning of 2022 in response to soaring inflation, which had exceeded the 2% target rate set by these central banks.
However, it is noteworthy that the UK’s response to inflation differed from that of the US and the EU, prompting discussions about the effectiveness of interest rate adjustments in managing inflation. These variations in responses have also prompted shifts in opinions regarding which Western economies are most susceptible to recession in 2024.
The primary aim of raising interest rates is to combat inflation by curbing consumer spending. The anticipation of higher interest payments encourages businesses and households to save more, potentially leading to reduced borrowing due to increased associated costs. Borrowers with existing loans may find themselves with reduced disposable income for goods and services after settling their interest obligations.
Governments are also affected by interest rate hikes, especially in the UK, where approximately a quarter of government debt is tied to inflation. This linkage results in a larger share of the budget being allocated to interest payments, leaving fewer resources available for public services when the central bank raises rates.
It is important to recognize that the consequences of rate hikes do not manifest immediately. Borrowers with fixed-rate loans are shielded from higher base rates until their existing loan terms expire. For instance, nearly a million UK borrowers are still benefiting from fixed rates of 2% or lower, which will only adjust to current, higher levels in the first quarter of 2024. This delayed impact of past interest rate increases poses challenges for central bankers in determining when rates have been raised sufficiently to cool the economy.
Increasing interest rates can also influence inflation by enticing foreign investors to acquire bonds and other financial assets denominated in a country’s currency. This influx of capital typically strengthens the nation’s exchange rate, resulting in cheaper imports and contributing to a deceleration in overall price increases.
A robust currency is particularly effective in moderating inflation for economies heavily reliant on imports, such as the UK. However, it can adversely affect exporters and is only effective when interest rates surpass those of comparable economies. This could explain the more assertive and extensive rate increases by the Bank of England compared to the ECB since February 2022.
Divergent Paths Ahead Despite similar rate hikes in 2022-23, these central banks are expected to embark on distinct paths in 2024.
US interest rates are projected to decline as inflation reverts towards the 2% target, with a notable drop to 3.1% in November 2023 from 6.4% in January. The US Federal Reserve has indicated its intention to reduce interest rates by a total of 0.75% in 2024, aligning with market expectations. In contrast, the ECB’s forward guidance suggests a similar downward trajectory in 2024, as projections indicate headline inflation decreasing to 2.1% in 2025.
The Bank of England, on the other hand, has signaled that its already higher base rate compared to the EU is likely to remain at 5.25% for an extended period. While inflation has eased to 4.6% in October, down from its peak above 11% in October 2022, households are bracing for additional cost-of-living increases, including a mid-winter 5% rise in the energy price cap. Moreover, the recent depreciation of the pound against the dollar has amplified raw material costs for industries, which could worsen if UK interest rates are reduced prematurely.
Lingering Recession Concerns Although the UK economy managed to evade a recession this year, despite minimal growth, some analysts still anticipate a UK recession in 2024. This expectation stems from the Bank of England’s decision to double its base rates from 2.25% in October 2022 to 5.25% by August 2023. Interestingly, consumer spending has been less impacted by higher borrowing costs than private and public investments, which are pivotal drivers of economic growth.
Additionally, there are concerns that the current interest rate patterns suggest the possibility of a US recession in a presidential election year. Most US GDP forecasts for 2024 fall within the range of 1.5-2.0%, a substantial decrease from the 4.9% recorded in the third quarter of 2023. Against this backdrop, the eurozone’s official projection of 1.2% growth in 2024 may be perceived as relatively robust, as it is not expected to decelerate as sharply as the US in 2024.
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