September 25, 2023 - 7:00am

Word on Wall Street is that interest rate hikes by central banks across the world are coming to an end. With inflation falling in most developed countries and global growth slowing, traders and analysts in financial markets are taking a breather. 

After the Bank of England announced that it would keep rates on hold last week, hedge funds have rushed to unwind their short bet against British gilts — indicating that they think interest rates aren’t going any higher.

It is certainly possible that rate hikes may be finished. But while inflation is currently falling in most developed countries, there is every chance that it may still persist in the face of rising energy prices. 

Saudi Arabia and Russia have indicated that they want to push global oil prices to $100, with the Brent oil price in Europe up nearly 31% over the last few months. These energy price increases are already noticeable in the motor oil inflation numbers in August, and it seems likely that they will become more pronounced in the coming weeks.

Even if energy prices do not cause inflation, it is far too early for central banks to take a victory lap. If history teaches us anything, it is that during interest rate hiking cycles, policymakers always talk up the prospect of a “soft landing” where prices stop rising and economic growth continues. But they almost never deliver on these promises.

The potential for a soft landing seems particularly unlikely this time around. This is because central banks are committing to maintaining higher interest rates for the next year or two. That means that mortgage rates will remain high and the housing market will get squeezed tightly, even if rates don’t go any higher — which they might. House prices are already falling in most developed countries, and housing starts have begun to decline. 

Present house price valuations are simply not viable with interest rates at these levels. Relatedly, would-be borrowers cannot afford repayments. So, if the mortgage rates are going to stay high, it is the house prices that will have to adjust — and that is precisely what we are already seeing.

Housing market bulls have been hoping that inflation would fall rapidly and that central banks would respond by dropping rates back down to zero. But central banks are clearly signalling that this is not going to happen. It now seems all but inevitable that housing valuations will have to adjust to return the market to equilibrium. Expect some overshoot too, because when housing markets adjust, they tend to adjust chaotically as the speculators in the market are shaken out.

The last time the Bank of England started a rate hiking cycle was in August 2006. Interest rates peaked a year later in July 2007. The recession did not set in, and unemployment did not start rising until May 2008 — just one month after the beginning of annual declines in house prices. This clearly shows the lagged nature of the impact of rising interest rates on the economy. 

Of course, every cycle is different. House prices in Britain have declined for seven consecutive months. The annual decline in August was 5.3%, a fall last seen in June 2008 when the economy was haemorrhaging jobs. As the traders celebrate the fall in inflation and the hedge funds stop shorting British Government debt, a look at past trends reveals trouble ahead.

Philip Pilkington is a macroeconomist and investment professional, and the author of The Reformation in Economics