The Federal Reserve (Fed) held its target for the federal funds rate in a range of 5.25%–5.5% on 20 September, followed by the Bank of England’s (BoE) decision to hold its bank rate at 5.25% on 21 September – ending a series of 14 successive rate hikes in the UK since December 2021.
Both central banks emphasised the need to remain vigilant to return inflation to their 2% targets.
Vanguard believes that one to three more quarter-point hikes may be required by the Fed to achieve its 2% goal, with the US central bank predicting core inflation won’t come down to target until 2026. We believe that policy rates are close to peaking, or already have peaked, in the UK and the euro area.
Economic activity has slowed notably in both places. (The European Central Bank raised its policy interest rate by a quarter percentage point to 4% on 14 September.)
UK inflation data released on 20 September likely influenced UK policymakers, who were debating whether to maintain the bank rate or raise it by a quarter percentage point. Both headline and core inflation in the UK remain above 6% and far above the BoE’s 2% target.
Pressures on core inflation (which excludes alcohol, tobacco, food and energy prices) eased sharply in August, led by services, but wage growth remained elevated—the annualised rate was more than 8% in the private sector for the three months ending 31 July—and rising oil prices represent another risk. If wage growth and energy prices remain strong, we see a risk that the UK’s bank rate may need to go higher still.
"Once the terminal rates are reached, they’re likely to stay there for an extended period."
Senior Economist, Vanguard, Investment Strategy Group
In the US, inflation has moderated faster than in the UK, although core inflation, which excludes volatile food and energy prices, above 4% is still more than double the Fed’s target.
We think US inflation numbers are moving in the right direction, allowing the Fed to take more of a wait-and-see approach. At the same time, we believe a resilient economy—particularly a resilient services sector—keeps the potential for further rate hikes on the horizon.
For the Fed to really succeed in reining in inflation, we think more is needed - whether through further marginal increases in rates or by keeping rates higher for longer. Along with its 20 September decision to hold rates, the Fed projected that its interest-rate targets in 2024 and 2025 are likely to be half a percentage point higher than it had projected in June.
While rates may have peaked or are close to peak, we don’t think investors should expect central banks to start cutting rates immediately.
Once interest rates reach terminal levels, they’re likely to stay there for an extended period and we’re not expecting to see rate cuts in either the US or UK until the second half of 2024.
This is where Vanguard’s view really differs from the market consensus, which seems to anticipate rate cuts starting in early 2024.
One factor behind our belief is that the neutral rate of interest—the theoretical rate that neither promotes nor restricts economic activity (also known as R-star)—is higher than many may imagine. We discussed this in detail during our last quarterly investment outlook webinar, which you can watch on demand..
The Fed, in its rate projections, kept its assessment of the neutral rate—the median of its long-run federal funds rate target projection—at 2.5%. Vanguard believes that the neutral rate for the US economy is closer to 3.5%, suggesting that a return to the low-rate environment of the recent past is unlikely any time soon.
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