With UK inflation higher than expected and interest rates now at 4.25% what’s ahead?

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The Bank of England’s latest 0.25% increase to UK interest rates takes them to 4.25%. Many hope it will be the last hike of the year but with inflationary pressures persisting, will that be the case? Read our outlook for inflation and interest rates. 

The Bank of England (BoE) increased UK interest rates by 0.25% to 4.25% at today’s meeting (23 March). Markets had been viewing the decision as too close to call until surprising inflationary data, announced the day before, tipped the scales in favour of a hike. Many are hoping it will be the last increase of the year, but with economic data looking strong overall, will that be the case?

We asked our colleagues at Phoenix Asset Management for their views on the outlook for inflation and interest rates.

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.

Were you surprised by the BoE’s decision? 

The decision makers – the nine members of the Monetary Policy Committee (MPC) – voted seven votes to two to increase interest rates.

On the run up to the announcement, markets were viewing the decision as finely balanced. However, a surprising increase in inflation for February, announced the day before the MPC meeting, tipped the odds in favour of a hike.

Economic data has been stronger overall. And while the collapse of Silicon Valley Bank (SVB) and concerns around the stability of Credit Suisse (subsequently taken over by UBS) caused short-term market volatility, the impact on the UK banking system was limited. It’s important to remember that UK banking is supported by strong capital ratios and ample liquidity – in other words, it’s better able to withstand unforeseen losses or market downturns.

This all means that the MPC could make the decision to increase rates without fear of the current financial disruption becoming a bigger issue.

The measures announced in the Spring Budget also added to medium-term inflationary pressures. The Chancellor is deploying £21 billion in spending over the next fiscal year, which the OBR (Office for Budget Responsibility) estimates could add around 0.3% to GDP (gross domestic product) growth. This new ‘fiscal firepower’ demands a proportionate monetary response in the form of the 0.25% hike we’ve seen. 

Does stronger economic data mean the UK will avoid a recession?

Our view at Phoenix Asset Management is that economic data points to the recession being short and shallow. But we still expect economic activity to contract for three quarters in the first nine months of the year; a technical recession being two consecutive quarters of negative growth.

The good news is that business sentiment has improved, with future business expectations in the services sector at its highest level since May 2022. There are signs too that the labour market is keeping robust. The unemployment rate remains at 3.7% – slightly lower than the BoE was expecting. Meanwhile the number of open vacancies is well above pre-pandemic levels. 

However, we believe the total 4.15% in rate increases we’ve seen in this hiking cycle are yet to fully feed through to households and businesses. 

Inflation data for February was higher than expected. What’s your outlook overall?

Inflation increased to 10.4% in the 12 months to February, up from 10.1% in January. This was 0.5% higher than the BoE expected. Although fuel prices continued to fall, costs in other areas rose; notably food prices (driven by the shortages we saw in vegetables and salad) alcohol and clothing. 

Core CPI (consumer price index), which strips out price changes for energy and food – as these are more volatile – was also significantly higher at 6.2% (the Bank's forecast being 5.8%). 

We may be past the extreme highs in inflation we saw last year – reaching 11.1% in October – but the BoE clearly sees risks that it remains ‘sticky’ and isn’t heading for the 2% target with sufficient speed. 

The outlook for inflation is still a fast deceleration from April onwards as we see the continuing fall in fuel costs reflected in the annual figure. Overall, we believe that headline inflation will still sit above 3% by the end of the year.

What does all this mean for your outlook for interest rates – have we seen the last hike for a while?

It’s a difficult balancing act for the BoE; rising interest rates to manage persistent inflation but not so much as to push the economy into a deep recession or to cause financial instability in markets. 

We believe that, given these risks, the BoE will act with caution when it comes to future interest rate moves. The Bank would like to have a period of time to allow for its series of 11 consecutive increases to feed into the economy – it takes time for changes to interest rates to filter through the economy to the products we buy and the services we use. 

For this reason, we believe this sequence of interest rate hikes has drawn to a close at 4.25%.

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The information here is based on our understanding in March 2023 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.