UK inflation and interest rates – what lies ahead in 2023?

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With UK interest rates now at 3.5%, what lies ahead? We look at the outlook for inflation and interest rates and the key factors for investors to watch out for in 2023

The Bank of England's 15 December decision takes UK rates to 3.5%, marking its ninth increase in a year. It's the latest step to tackle soaring inflation, which, while falling by more than the market expected in November, remains historically high at 10.7%.

Recent economic data has been mixed, so has the Bank done enough to halt inflation – and what's the potential economic cost of doing so? We asked our investment colleagues at Phoenix Asset Management for their thoughts.

Standard Life is part of Phoenix Group, the UK's largest long-term savings and retirement business. We work closely with our colleagues at Phoenix Asset Management to determine the outlook for markets and the investment strategy for our pension solutions. They have provided the following views.

Did the Bank of England act as markets were expecting?

Yes, as expected, the Monetary Policy Committee (MPC) voted for a 0.5% increase, taking rates to 3.5%. This slows the pace of tightening from their 0.75% hike in November.

Once again, it wasn't a unanimous vote; revealing further disagreement among MPC members about where interest rates should ultimately reach. While six of the nine members voted for the 0.5% increase, one voted for a 0.75% hike and the other two members believed there was no reason to raise the rate.

There's good reason for these differing views. Recent economic data has been mixed, with higher than expected wage growth and continuing inflationary pressures. However, there are signs that 12 months of increasing interest rates is taking effect, with a rapidly slowing housing market and business surveys pointing to a recession. 

What's your view on inflation?

The rate of inflation may well have peaked in October at 11.1%, but we expect it will prove to be rather ‘sticky' in 2023. We believe it will fall to around 4.5% by the end of the year, as energy prices are unlikely to rise so rapidly next year, supply-chain disruption eases further and higher interest rates weigh on demand. 

How will inflation affect interest rates?

The Bank of England continues to hold pessimistic forecasts, both in absolute terms and relative to other forecasters. But ultimately, the point at which interest rates peak will be a process of discovery rather than a pre-set level. It's all largely dependent on how persistent inflation and wage pressures are over the next six months. 

As the economy enters a recession, Phoenix Asset Management view the Bank of England as a ‘reluctant hiker'. We believe that persistent inflation and the tight labour market will force the MPC to take interest rates to 4.5% by next May – a little higher than what we believe is their ideal landing zone.

What should investors be paying attention to in 2023? 

The key for investors in 2023 will be the economic cost of all these interest rate increases and just how quickly inflation can fall. 

It's likely to be a challenging year, as global economic growth slows to around 2%, with the US and Eurozone joining the UK in recession. 

Currently, it appears equity markets expect only a mild recession in the US and reduced cost pressures. This would allow the US Federal Reserve to begin to loosen monetary policy by the end of 2023. 

However, as we've mentioned, at Phoenix Asset Management we believe the risks are skewed to inflation remaining more pervasive. If that is the case, it will prevent the major central banks from cutting interest rates for the whole of next year – and the economic landing will be that much harder. 

Certainly, in the UK, we believe the economy will contract by -1.3% in 2023, before recovering very slowly in 2024. The cost of living crisis is likely to continue to weigh on household disposable income in 2023, as pay rises fail to keep up with inflation. 

But rising wages will likely mean an intense squeeze on corporate profits over the coming months and a drop in labour demand – with the unemployment rate, currently 3.7%, expected to increase to 4.8% by the end of next year. However, unlike previous recessions, this one is likely to be a ‘job-full' recession. This means we expect companies to continue to hire where appropriate and to avoid making mass redundancies – many are likely to look to cut costs elsewhere before letting go of key skills that they may find difficult to hire back.

With more challenges ahead, we'll continue to monitor the situation and provide timely economic updates. 

You can read more insight on pensions and investments on the articles section of our Workplace website.

The information here is based on our understanding in early December 2022 and shouldn't be regarded as financial advice. The value of pension plans and other investments can go down as well as up and may be worth less than what was paid in.