City economists doubt Bank of England will raise rates to 4.75%

City economists are challenging market expectations that the Bank of England will raise interest rates to 4.75% or higher by next summer. They argue that traders have overpriced the likely pace of tightening, with little evidence that energy costs are feeding into broader inflation.

Market pricing versus economic forecasts

Financial markets currently imply the Bank rate will climb from 3.75% today to at least 4.75% by the end of July, and possibly 5% by December 2027. That would require four or five quarter-point increases over the next year. But James Smith, developed markets economist at ING, told a City briefing last week that such a path is unrealistic. “If you look at the swaps market, and you look at what’s priced in for the Bank of England, you’ve got four rate hikes and then no cuts ever. And I think you’d be hard-pressed to find anybody that really agrees with that,” he said.

Smith believes the Bank could signal an all-clear by next spring and start cutting rates by the end of next year. Sanjay Raja, chief UK economist at Deutsche Bank, also doubts the market pricing. “I do not believe that any mainstream forecaster thinks the Bank of England will hike to 5% by the end of next year with the information set we have today,” he said. Raja estimates that once risk premia are stripped out, only about half a percentage point of hikes is actually pencilled in. Deutsche Bank’s base case sees the Bank rate reaching 4.25% by next February and then staying on hold until the end of 2027.

Why markets are pricing more hikes

Economists say market-implied rates have become closely correlated with oil prices since the war in Iran began. As oil prices rise, traders price in more rate increases. But many traders were burnt at the start of the current Middle East crisis, having positioned for rate cuts this year. Now they are reluctant to take the opposite risk until there is greater certainty about energy supply and winter inflation. “It can get pretty painful, so a lot of traders are quite reluctant to take this risk until there’s greater certainty about energy supply and the extent of inflation this winter,” Smith said.

Other forecasters agree. Morgan Stanley’s base case is for rises in November and February, with rates on hold thereafter. Oxford Economics expects quarter-point increases at the November and February meetings, taking the Bank rate to 4.25%—significantly below the market peak of 4.75% to 5%.

What the Bank of England might do

The Bank is widely expected to raise rates to 4% at its next meeting on 5 November, after UK inflation rose to 3.5% in September. Goldman Sachs last month said its probability-weighted forecast for the Bank rate was “notably below market pricing” and expects a rise to 4% next month. Huw Pill, the Bank’s chief economist, told an International Monetary Fund meeting in Bangkok this month that he was sceptical the Bank would need to raise rates four times over the next year. Morgan Stanley also noted that additional pressure to raise rates could come if the Low Pay Commission recommends a larger increase in the national living wage than expected. But for now, most City economists see the market pricing as too aggressive.