The Bank of England hiked interest rates to 3 percentage points on Thursday from 2.25 percentage points, its largest rate since 1989 as it cautioned of a “very challenging” outlook for the economy.
Notably, the central bank predicts inflation will reach a four-decade high of around 11% during this last quarter of 2022, but that Britain has already gone into a recession that could probably last two years – longer than the 2008-09 financial crisis.
Thursday’s decision – the greatest in 33 years not counting a failed attempt to support the pound on Black Wednesday in 1992 – was in agreement with economists’ expectations in a Reuters poll, but was not unanimous.
Two policymakers, Swati Dhingra and Silvana Tenreyro, voted for smaller hikes of a half and quarter a percentage point respectively, as the economy was potentially already in recession.
But most of the Monetary Policy Committee said rates would need to be lifted further still, although possibly not as high as the 5.2% which was priced into financial markets when the BoE concluded its forecasts.
The Bank of England said in unusually specific guidance to investors:
“Further increases in Bank Rate may be required for a sustainable return of inflation to target, albeit to a peak lower than priced into financial markets.”
Just prior to Thursday’s policy decision, markets projected rates to peak at around 4.75%.
The MPC added:
“The Committee continues to judge that, if the outlook suggests more persistent inflationary pressures, it will respond forcefully, as necessary.”
Central banks across the Western world are dealing with similar challenges. Inflation has surged over the past year owing to residual labor shortages and supply-chain snags since the COVID pandemic and – in Europe’s case – a sharp rise in energy bills since Russia sent troops into Ukraine in February.
The U.S. Federal Reserve jacked up its key interest rate by 0.75% on Wednesday to a range of 3.75-4.0%, and the European Central Bank raised its deposit rate by the same amount to 1.5% last week. The Fed said future rate hikes might occur in smaller steps.
In that context, the BoE has encountered weeks of political and financial market turmoil since its previous rate hike on Sept. 22, as just the next day former Prime Minister Liz Truss’s government announced an unfunded 45 billion-pound ($52 billion) package of tax cuts that received a slamming response from investors.
This policy was designed to avoid recession and induce long-term growth – but instead, it drove sterling to an all-time low against the U.S. dollar, forced the BoE to buttress the bond market, and prompted Truss’s resignation.
Markets are currently more stable, with British government borrowing costs largely back to where they were prior to the turmoil. On Tuesday, the BoE was able to start selling bonds from its 838 billion pounds quantitative easing stockpile.
However, the underlying problems facing the British economy persist. Consumer price inflation returned to a four-decade high of 10.1% in September, and is expected to have jumped further in October when regulated energy prices increased – despite costly subsidies to limit the rise.
At the same time, the economy is weakening sharply, as rocketing inflation curbs consumer spending on discretionary items.
The Bank of England forecasts that Britain’s economy went into recession in the third quarter of this year and that the recession will last until mid-2024, causing the economy to contract by 2.9%. Unemployment would increase steadily to 6.4% by late 2025, a rise from 3.5% now, its lowest since the mid-1970s.
Buy Crypto NowIf the Bank of England does not hike rates higher, the recession would be short-lived – with a quarter of growth in the middle, and a cumulative loss of output of about 1.7%
But inflation would be slightly slower to decline, remaining just above 2% in two years’ time, against some way below if the BoE hikes rates as much as markets had earlier projected. The BoE’s policymaking is made particularly complicated by a lack of clarity over future government policy.
While most of Truss’s tax cuts have been undone, incumbent Prime Minister Rishi Sunak has stated there will need to be a squeeze on public spending and probably higher taxes, the scale of which will not be clear until a fiscal statement on Nov. 17.
Energy subsidies are expected to cease in their current form in April, but the BoE in its estimates assumed they would continue at nearly half their current size, staving off a steep further rise in inflation in 2023.