U.K. economy remains on course to shrink despite rate hikes and improved inflation outlook

Money managers in Europe still expect the U.K. economy to contract, despite the Bank of England’s latest 50-basis-point rate hike and a more subdued inflation forecast.

The European Central Bank also announced a 50-basis-point hike on Thursday, and penciled in another rise of 50 basis points in March.

The BOE raised interest rates to 4% on Thursday, while also indicating, according to some money managers, that it is now less likely to continue to hike rates in 2023.

The BOE’s monetary policy committee, which sets policy to meet a 2% inflation target, voted by a 7-2 majority to increase rates. Two members of the committee voted to maintain rates at 3.5%, the bank said in an update.

Ed Hutchings, head of rates at Aviva Investors, said in an emailed comment that the U.K.’s central bank delivered a hike in line with market expectations. “However, just like the December meeting, there was a split of votes once again, with some members voting for no hike at all. It’s clear there is still much uncertainty amongst MPC members,” he said, adding that the minutes of the meeting indicated the prospect of a shorter and shallower recession.

Vivek Paul, U.K. chief investment strategist at BlackRock Investment Institute, said in a separate emailed comment that the BOE’s decision “gets us closer to the end of the monetary tightening cycle in the UK — but we’re not yet done.”

Mr. Paul added: “The damage to the U.K.’s real economy is only starting to be seen — the effects of the rate hikes are lagged, so the recent near-term growth resilience should not be extrapolated. Despite the bank upgrading its own forecasts, they still forecast a contraction — and we believe the U.K. will feel more pain than its peers.”

Mr. Paul added that inflation is set to fall but, in the long run, will remain above the BOE’s target due to supply shortages.

The MPC’s updated projections show consumer price index inflation falling back sharply from its current very elevated level. Annual CPI inflation is expected to fall to around 4% toward the end of 2023, from 10.5% in December, the update said.

But some managers also said the MPC’s meeting minutes indicate that the latest hike may be the last this year for the U.K., as long as inflation remains under control.

Fredrik Repton, portfolio manager with the global fixed income and currency management teams at Neuberger Berman, said in an emailed comment: “On the one hand, the labor market is stronger than they had expected and they have revised up forecasts for the economy as a whole.”

But he added that the BOE now expects inflation to drop markedly due to the base effects in energy prices and has indicated a more dovish approach to future rate hikes.

Other managers said that the bank rate could be near its peak. Hussain Mehdi, macro and investment strategist at HSBC Global Asset Management, said in an emailed comment: “Despite a still soggy growth outlook, the Bank has delivered another big hike amid concerns over the inflation outlook given a still very tight labor market and high wage growth. However, with policy in restrictive territory and activity indicators deteriorating, we think bank rate is now near its peak.”

“The big question is now the speed in which the MPC can reverse course on rates. A downside risk for markets and the economy is a long period of restrictive policy to deal with persistent underlying inflation. We retain a cautious view on U.K. and European stocks in the face of downside risks to GDP and corporate earnings growth relative to consensus expectations and believe the recent rally to be unsustainable,” he added.

The ECB rate increase was also in line with market expectations, said Orla Garvey, senior portfolio manager for fixed income at Federated Hermes.

“(Christine) Lagarde’s press conference was notably less hawkish than the last, noting the marked declines in money growth; but she stuck to the outlook for another 50 (basis points) in March,” she said in an emailed statement, adding that central banks are coming towards the end of their hiking cycles and they have done enough to bring inflation back to target.