What the hedgehog tells us about interest rate forecasts

On 13 December 2023, the US Federal Reserve (Fed) signalled its willingness to cut interest rates at the first sign of weakness.  Just days later at the Bank of England (BoE)’s December meeting, the BoE maintained its view that rates need to stay higher for longer, despite UK inflation having come in much lower than consensus. They also stated that “further tightening in monetary policy would be required if there were evidence of more persistent inflationary pressures”. Contrasting this BoE statement, the market has priced in substantial rate cuts for 2024 and 2025.

History shows there are inconsistencies between what market participants price in versus actual rate changes.

From 2009 to the start of 2017 the market was pricing in higher interest rates. However, the BoE held rates relatively flat over this period. Similarly, at the start of 2022, markets were pricing in hikes of 1 to 2% over the following year; however, the BoE hiked rates substantially more.

Recently, we have also seen market participants simply extrapolate recent history. The November 2022 dotted line shows the market overreacted regarding the magnitude of rate hikes needed to cool inflation after the BoE raised rates by 0.75%. Just over a year later, in December 2023, this type of extrapolation occurred again following the Fed pivot, with markets expecting rates to be cut in quick succession.

This demonstrates that markets are unable to consistently predict what central banks will do next. Those policy forecasts are typically the bedrock for equity, bond and housing market outlooks. The next time you hear an economist or strategist talk with certainty about a single market outcome, remember that history strongly suggests that certainty on the prediction of one outcome is probably a castle built on sand. However, predictions which consider several possible scenarios have a substantially stronger foundation.

Prepare, don’t predict.