The forecast from the Bank of England that the UK economy is heading for a prolonged recession is sobering. As it increased interest rates by 0.75 of a percentage point, the biggest increase in 30 years, the bank set out a couple of possible scenarios, one involving a recession lasting for over one year and the other a downturn lingering on for two years. Because the outlook is now so poor, it signalled that its base interest rate – now 3 per cent – might not have to rise much further.
While there was some sense of calm restored after Rishi Sunak became prime minister and reversed tack on a lot of the policies outlined by the short-lived administration of Liz Truss, the move by the Bank of England shows that a long road lies ahead for the UK economy. Hamstrung in export markets by Brexit and with a significant current account deficit, the UK needs to retain the confidence of lenders, while trying to find a way forward. The bank’s job is to bear down on inflation and the fact that it feels interest rates may now be near a peak underlines its belief that the downturn to come will be significant. Central bankers feel that recession may be the necessary price of controlling inflation, but politicians tend to take a different view.
The poor outlook for the UK economy is not good news for Ireland. The economic ties between Ireland and the UK have diminished over the years, but are still significant. Irish exporters, notably SMEs, will feel the impact of the UK recession. At some stage they will also be hit by greater post-Brexit border checks and regulations – the implementation of many on trade from Ireland to Britain post-Brexit has been delayed.
The sharp upward trend in UK interest rates and another big increase by the US Federal Reserve Board this week may also point the way to higher interest rates in the euro zone. ECB president Christine Lagarde has said that euro zone rates do not need to mirror those in the other major economies. But she has also warned that even if the euro zone moves into a “minor recession” this, on its own, would be unlikely to be enough to bring down inflation. In other words interest rates would need to continue to rise.
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With the ECB deposit rate at 1.5 per cent compared to Bank of England rates of 3 per cent and US rates of 3.75 to 4 per cent, there could still be significant rises ahead for borrowers here. Euro zone rates are likely to increase to at least 2 per cent by the end of this year, though the outlook for 2023 will be hotly debated by the ECB governing council at its next meeting in December.
Just like its counterpart in London, the ECB could soon be dealing with a recessionary threat with inflation still stubbornly high. Against this backdrop, there are no “right” policy answers, but central bankers need to take care not to overdo the monetary medicine.