The proposed mini budget raised investors’ concerns about future inflation and U.K. debt sustainability. In response, sterling fell against the dollar and euro, and bond prices fell across a range of maturities. The speed at which bond prices fell exposed vulnerabilities in strategies that certain pension funds had used to manage their balance sheet. It forced them into bond sales amid margin calls.

The near-crisis appears to have abated after a new chancellor was appointed and the government reversed course on much of the mini budget. But it is worth stepping back and considering why markets are volatile. A combination of factors has contributed, including the strong post-COVID recovery and tight labor market, the war in Ukraine and European energy crisis, and central banks’ efforts to tackle multidecade-high inflation. To return inflation to their 2% target, central banks in the United States, the euro area, and the U.K. have communicated the need to continue raising rates in earnest, such that high inflation does not become embedded into the economy.

Interest rates have increased rapidly over the past six months, and that pace is expected to continue. The charts above show expectations for how high rates will go. They are significantly higher now than they were last month, particularly for the Bank of England. And they are materially higher than where they were at the end of last year. Our view is that policy rates in these major economies will continue to rise into March 2023.

Vanguard believes that central banks will adhere to their inflation-fighting paths unless “something breaks”—an economic sacrifice or market threat beyond the controlled slowdown they are trying to engineer. Of course, the path of policy will depend on future events and data outturns. In our recent Global Macro Matters research, Getting Inside the Fed’s Head, we discuss how good luck with respect to energy prices, inflation expectations, and labor markets could result in a lower terminal rate of interest. A series of unlucky shocks, however, may give rise to a higher terminal rate. 

This extraordinary economic environment breeds volatile conditions that can spread to distinct parts of the market, broadly increasing risk. Where, when, and even whether other such crises-in-waiting may materialize isn’t clear. In recent weeks, debates have arisen about the fundamental health of a major European bank and a sovereign European nation.

Investors need to understand that financial markets may face continued shocks until they find their footing. That’s why markets are so keen to nail down the final destination for the global macroeconomy. Can major central banks navigate the economy’s return to a world of low and stable inflation, a world we know well and desire? If so, what will it take to get us there?

What is turning into a sprint toward the terminal interest rate reflects policymakers’ sincere belief that, by acting decisively, they can bring us back to that comfortable world. Fragilities in the U.K. pension sector were a wake-up call that the journey will be bumpy. Markets struggle with those bumps. They crave the certainty that policymakers are poised to succeed. And these days, certainty is in short supply.

• Getting inside the Fed's head (global macro matters, issued September 2022)
• Brighter prospects ahead for fixed income (article, issued October 2022)
• Vanguard CIO addresses a dismal market (article, issued September 2022)
• Can bond investors benefit from inflation and rising interest rates? (article, issued September 2022)
• Vanguard forecasts: Driven by research, data, and debate (Vanguard Global Chief Economist Joe Davis 1-minute video, issued September 2022)