BOE Raises Rates to 5.25% With Warning Policy Will Remain Tight

The Bank of England raised interest rates to a new 15-year high, warning that its fight against inflation may require tighter borrowing conditions for an extended period.

(Bloomberg) — The Bank of England raised interest rates to a new 15-year high, warning that its fight against inflation may require tighter borrowing conditions for an extended period.

The UK central bank lifted its key rate a quarter point to 5.25% on Thursday, which was in line with market expectations after a surprise half-point increase in June. Still, signs of debate between policymakers prompted traders to pare bets on the pace of further hikes, with markets priced in for rates to peak below 5.75% in February. 

The Monetary Policy Committee left the door open to further action if inflation persisted, and added language saying their stance would remain “sufficiently restrictive for sufficiently long” to bring it back to the 2% target. The bank reduced its growth forecast over the next two years and raised its outlook for inflation over the medium term.

“We have to balance the risks here, and we’ve got risks both ways,” Governor Andrew Bailey told a news conference after the decision, adding there were different paths to reach the target inflation rate of 2% — including by keeping rates unchanged over the medium-term. “There is no presumed path of interest rates.”

The BOE will have two more months of crucial inflation data before its next meeting in September. Asked when the bank would reverse course, Bailey said it was “far too soon to speculate on when we might see a cut.”

Prime Minister Rishi Sunak has so far backed the BOE in its fight against price increases, even though the bank’s forecasts signaled a bleak backdrop for the next general election, which is expected to be held next year. The bank indicated the rate of inflation could fall by more than half this year to 4.9%, meeting a key pledge of Sunak’s. 

The pound initially extended losses after the decision and short-dated gilts gained as traders pared bets on further interest-rate hikes. The currency pared its declines to trade 0.2% weaker at around $1.27 as of 1:45 p.m. in London. The yield on two-year notes was 7 basis points lower at 4.92%.

The decision indicated a divide on the nine-member MPC about how the BOE should respond to indicators showing that wages and prices are rising too fast for comfort while activity in the economy is weakening.

Catherine Mann and Jonathan Haskel voted for a half-point hike. Swati Dhingra sought no change. The remaining six including Bailey and his deputies were in the majority and noted that their action will weigh heavily on households and businesses.

“The vote split indicated we are nearing the peak now,” said Luke Hickmore, an investment director at Abrdn. “Some of the language used today also suggests they are getting nervous about the economy’s reaction to the hikes in place so far.” 

What Bloomberg Economics Says… 

The Bank of England’s decision to step down the pace of tightening in August suggests it is a little less troubled by the inflation outlook than it was in June. That said, the messaging around the decision suggests there is a little further to go in the tightening cycle before the central bank will feel comfortable pausing.

-Dan Hanson, Bloomberg Economics. Click for the REACT.

The BOE maintained its guidance that “if there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required,” minutes of the meeting showed. It added a sentence suggesting that once the tightening cycle was finished, rates might remain elevated for some time.

“The MPC would ensure that Bank Rate was sufficiently restrictive for sufficiently long to return inflation to the 2% target sustainably in the medium term, in line with its remit,” it said. Key indicators, especially wage growth, “suggest that some of the risks from more persistent inflationary pressures may have begun to crystallize.”

Economists were divided before the decision over how aggressive the BOE would be. Of the 61 economists surveyed ahead of the meeting, 45 expected a quarter point rise in Bank rate and the rest predicted a half-point increase. 

Investors read the decision as an indication that borrowing costs will peak sooner as inflation cools. Little under a month ago, traders had priced in terminal rates in excess of 6.5% with some economists warning that 7% was a possibility. 

The BOE confirmed that it would decide next month on the pace of its effort to run down its balance sheet of bonds built up during a decade of quantitative easing. The second year of so-called quantitative tightening will begin in October.

The central bank’s forecast indicated the UK economy would avoid a recession ahead of a general election. However, the charts indicating the range of possible scenarios show there is still a significant risk of a contraction.

Britain’s economy will likely stagnate through to 2025, according to the BOE forecasts. It expects gross domestic product to grow 0.5% in both 2023 and 2024 and by 0.25% in 2025. By the end of the forecast period in 2026, GDP will be 0.75% lower than estimated in May.

The committee agreed that slack in the economy was likely to emerge as the quickest cycle of rate hikes in three decades cuts into the money consumers and businesses have to spend. Unemployment is likely to increase to almost 5% by the third quarter of 2026 from 4% currently, and vacancies have already started weakening.

While the UK’s rate of inflation fell to 7.9% in June, it’s still the highest among Group of Seven nations. Price pressures in the services sector also cooled for the first time in six months, though the BOE said they are expected to remain around their current “elevated” levels. 

“If we stick to the plan, the Bank forecasts inflation will be below 3% in a year’s time without the economy falling into a recession,” Chancellor of the Exchequer Jeremy Hunt said in a statement. “But that doesn’t mean it’s easy for families facing higher mortgage bills so we will continue to do what we can to help households.”

The latest increase in Bank rate will hit the finances of households with variable rate mortgages immediately. However, lenders are starting to cut costs of fixed rate deals on an improved outlook on inflation.

A quarter-point hike means that average monthly payments for households on variable rate mortgages have increased by £489 since the BOE started raising rates in December 2021, according to UK Finance.

“There is a risk of overtightening,” Martin Weale, professor of economics at King’s College London and one-time MPC member, told Bloomberg TV. “But hindsight’s a wonderful thing and, if there is a recession and inflation does come down quickly, then people will say the bank overtightened.”

–With assistance from Andrew Atkinson, Eamon Akil Farhat, Stuart Biggs, Constantine Courcoulas and Alex Mortimer.

(Updates with market reaction in second paragraph. A previous version corrected the number of economists surveyed by Bloomberg.)

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