Bank of England takes interest rates to a 14-year high

After yesterday’s fourth consecutive 0.75 percentage point interest rate rise from the Federal Reserve, the Bank of England has finally decided to follow suit. This afternoon the BoE announced a rate hike of 0.75 points too, the first rise of this size in 33 years. This takes UK interest rates from 2.25 per cent up to 3 per cent – a 14-year high.

A 0.75 per cent had been expected by markets – the broad consensus of what the Bank would do after a tumultuous month of interventions, spikes in borrowing costs and inflation returning to double digits. There was general consensus on the Monetary Policy Committee, too, with a vote of 7-2 for the 0.75 percentage point increase (the other two votes were for a softer rise). Still, the pound fell 2p against the dollar less than an hour after the announcement – it’s clear the MPC are rather hesitant to be moving at this pace, leading to suspicion that future hikes may not be so bold. 

It was just weeks ago that markets were predicting a much bigger hike, closer to 1.25 percentage points in one go, to help steady the market reaction to Liz Truss’s mini-Budget (which has now almost completely been dismantled). This was the unspoken part of Truss’s (short-lived) agenda: to rebalance fiscal and monetary policy. The economists advising her were rather explicit about this during the leadership race. Interest rates had been too low for too long, they said, and looser fiscal policy (i.e. more borrowing and spending) was supposed to create some room for the Bank of England, independent from the Treasury, to tighten monetary policy. The hope was that the BoE would feel confident to be bolder on interest rates and get inflation back under control.

But the mini-Budget opened Pandora’s box, and the desired, rather modest rise in interest rates exploded into market expectations of economy-wrecking rates. Just a week after the mini-Budget, interest rates were expected to peak around 6.5 per cent. This was close to the 7 per cent Rishi Sunak warned about on the Tory leadership campaign trail – and a large part of the reason he’s now in No. 10. Since rolling back the mini-Budget, market predictions for peak interest rates have settled just under 5 per cent.

As Sunak and his chancellor Jeremy Hunt plan to cut spending and raise taxes in the Autumn Statement on 17 November, warnings of a recession are getting louder. Indeed, the Bank’s report today suggests the economy is ‘expected to be in recession for a long period’, until mid-2024, with inflation peaking around 11 per cent. 

This has some wondering if the Bank is right to keep pushing interest rates up, which risks further stifling economic growth and puts more pressure on household finances, changing people’s spending habits just as the economy is taking a downturn. Risking recession is one of the primary reasons the Bank is thought to have moved so slowly on rate hikes. But failure to move has contributed to the runaway inflation Britain is experiencing now, with the headline CPI rate 8 percentage points higher than the Bank’s target. 

The BoE clearly felt the need to respond to these concerns this afternoon, opening its Monetary Policy report by stating the trade-offs: 

‘Inflation is too high. It is well above our 2 per cent target. High energy, food and other bills are hitting people hard. If high inflation continues, it will hurt everybody. Low and stable inflation helps people plan for the future. Raising interest rates is the best way we have to bring inflation down.’

The big risk that the Bank points to here is that temporary inflation becomes permanent; that price hikes become baked in, causing long-lasting financial pain. The Bank’s updated forecast puts headline CPI just above 5 per cent in Q4 of 2023, still more than 3 percentage points above its mandated target. But this scenario may be on the optimistic side. Capital Economics expects inflation to still be hovering around 7.5 per cent at the end of the next year. How quickly inflation falls will, in part, be determined by what the Energy Price Guarantee is replaced with next April, as it’s expected that the support will become more targeted, with those on higher incomes (potentially) paying higher bills.

Rising rates are an international story, and despite last month’s forecast spikes, predictions for the UK’s interest rates are now falling back in line with international counterparts. But unlike the Federal Reserve, which has been giving hints in its recent updates about its medium-term thinking, the BoE is keeping all options on rates open, asserting that ‘what will happen to interest rates will depend on what happens in the economy’.

The rollback of most of the mini-Budget, and the expected fiscal tightening in the Autumn Statement, gave the Bank more room to lean on the dovish side of the rate hike. The MPC members took it. Today’s rather defensive statement suggests a level of nervousness too. With broad consensus now that the UK is headed for recession – if not in one already – expect the Bank’s future decisions to try to strike a balance between tackling inflation and avoiding the recession blame-game.