Originally published at: This week in charts: To cut or not to cut? – InvestEngine Insights
Inflation rising
This week saw the release of the UK’s latest inflation figure, with the Consumer Price Index (CPI) hitting 2.6% in November. Inflation rose for the second consecutive month, and at the fastest pace since March, surpassing October’s 2.3% rate but aligning with forecasts. Fuel and clothing price rises were the main drivers of the increase.
Core inflation, which excludes volatile items like energy and food, climbed to 3.5%, up from 3.3% in October, while services inflation remained steady at 5%, slightly exceeding the Bank of England’s 4.9% projection.
While, on the face of it, higher inflation tends to be bad news for markets, it was always expected that inflation would accelerate at this point in the year. Because energy costs fell significantly a year ago, the point of comparison when calculating annual inflation is lower than usual. However, core inflation, which excludes energy costs (and is therefore less impacted by the so-called “base effects”), is still rising, causing concern for BoE policymakers and reducing the expected pace of cuts for 2025.
Bank of England keeps rates on hold
Following the inflation data release on Wednesday, Thursday saw the Bank of England maintain interest rates at 4.75%.
The vote was split 6-3 in favour of keeping rates on hold, with Monetary Policy Committee (MPC) members warning that increases in wages and prices had “added to the risk of inflation persistence”, dampening hopes of rapid rate cuts in 2025.
Andrew Bailey, BoE governor added that “We think a gradual approach to future interest rate cuts remains right. But with the heightened uncertainty in the economy, we can’t commit to when or by how much we will cut rates in the coming year.”
Traders still expect the BoE to make two quarter-point cuts next year — the same as immediately before Thursday’s decision. That compares with the four the market expected as recently as October.
The UK central bank is now facing a difficult task. UK GDP has contracted for two consecutive months, and business confidence has weakened following Rachel Reeves’ tax-raising Budget in October. With a sluggish economic outlook, the market is looking for signs of easing monetary policy to stimulate growth. However, the combination of rising inflation and stronger wage growth means the BoE is still focused on keeping rates higher for longer to tame inflation. These two opposing forces make for a complicated path for the bank to tread next year.
UK gilt yields rise
With concerns mounting over the outlook for the UK economy, combined with accelerating inflation, borrowing costs for the UK government are rising past those seen following Truss’ mini-budget in 2022.
Gilt yields have marched higher over the last two weeks, also eclipsing the new high made last month after chancellor Rachel Reeves’ October Budget, which briefly unsettled investors by stepping up the Treasury’s debt issuance plans.
The recent increase in yields from less than 4.2% two weeks ago to 4.6% today has come as a result of upward revisions to the expected levels of interest rates next year. Higher government spending and borrowing in Reeves’ budget are likely to add to inflationary pressures.
The US cuts rates
Meanwhile, in the US, the Federal Reserve also met this week, cutting interest rates by 0.25% for the third time in a row. This brings their benchmark rate to a range of 4.25% – 4.5%.
Projections from the central bank show expected rates in the US to fall to around 3.5% by the end of 2026, higher than previously forecast. The policymakers also raised their forecast for core inflation to 2.5% in 2025, implying fewer cuts than previously forecast, and underscoring their inflationary concerns.
This surprise upwards revisions for inflation and interest rate outlooks took investors by surprise, sending an unwelcome tremor through markets.
Market impact
The 0.25% cut from the Fed was largely expected by investors, with markets seeing no cause for concern with the cut itself. What was unexpected, though, was the Fed’s indication of their intention to slow the pace of easing next year – reducing their outlook from 3 to 2 rate cuts in 2025.
This sent the dollar higher (as short-term currency movements are correlated with interest rates), and sent the market into a selloff.
The S&P 500 index fell almost 3% immediately following the revised guidance for next year, led by big tech. The tech-heavy Nasdaq Composite fell 3.6%, with Tesla falling 8.3%, Amazon falling 4.6%, and Meta falling 3.6%. Small cap companies, whose fortunes are more closely tied to the domestic US economy, were particularly badly affected, with the Russell 2000 falling 4.4% on the day.
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