City Economists Doubt Markets Are Right About Steep Bank of England Rate Rises

Financial markets are overestimating how far the Bank of England will push up interest rates, according to a number of City economists. Market pricing currently implies at least four increases over the coming year, which would lift the bank rate from 3.75% to 4.75% by the end of July, with a possible fifth rise taking it to 5% by December 2027.

Many forecasters see that path as unlikely, largely because there is little evidence that higher energy costs are feeding sharply into other prices. James Smith, a developed markets economist at the Dutch bank ING, said the swaps market implies four hikes and then no cuts at all, adding that anyone who agreed with that would be "hard-pressed" to be found.

Smith told a City briefing last week that the Bank could be "sounding the all clear" by next spring, and might be cutting rates again by the end of next year.

Market-implied rates are derived from the prices of financial instruments, including derivatives known as swaps, to show where traders expect rates to be in future. Economists point to several reasons for the elevated expectations. One is that they have tracked oil prices closely since the Iran war began: the higher oil has climbed, the more rate rises have been priced in.

That link makes it costly to bet against the market. An investor who is right about rates could still face mark-to-market losses and potential margin calls if oil keeps rising in the meantime. Smith said many traders are reluctant to take that risk until there is more certainty about energy supply and winter inflation. He added that many were caught out at the start of the Middle East crisis, having positioned for further rate cuts this year.

Sanjay Raja, chief UK economist at Deutsche Bank, said he does not believe any mainstream forecaster expects the Bank to reach 5% by the end of next year on current information, though he did not rule it out. He estimates much of the priced-in tightening is risk premia, the extra return investors demand to cover uncertainty. Stripping that out, he sees only around half a percentage point of hikes factored in. Deutsche Bank's base case is a rate of 4.25% by next February, held through the end of 2027.

The Bank is widely expected to lift rates to 4% at its next meeting on 5 November, after UK inflation rose further above target to 3.5% in September. Goldman Sachs, which also expects a rise to 4% next month, said last month that its probability-weighted path remained "notably below market pricing". Morgan Stanley's base case is for increases in November and February, then a hold, though it warned of extra pressure if the Low Pay Commission recommends a bigger-than-expected rise in the national living wage.

Oxford Economics forecasts quarter-point rises in November and February, taking the rate to 4.25%, which it called significantly below the peak in money market expectations of between 4.75% and 5%. Even Huw Pill, the Bank's hawkish chief economist, has suggested expectations are running too hot. He told an International Monetary Fund meeting in Bangkok this month that he was sceptical the Bank would need four rate rises over the next year.