The Bank of England (BoE) raised its key interest rate to 4% from the previous 3.75% on Thursday, marking the first increase in over three years. The central bank warned that additional hikes may be necessary if the conflict between the US and Iran keeps energy prices high.
The BoE stated that UK inflation is likely to reach around 5% by the middle of next year, more than double the central bank's target and a blow to new Prime Minister Andy Burnham, who aims to ease the pressure on the cost of living.
Although there is little evidence yet of inflation accelerating outside sectors directly affected by rising energy prices, the BoE noted that inflationary pressure caused by months of high energy costs requires an immediate rate hike.
Governor Andrew Bailey stressed that the current increase should not be seen as the start of an inevitable long series of hikes, but he also noted that if the Middle East conflict is not resolved, it is unlikely to be the last increase.
Disagreements within the Monetary Policy Committee
The Monetary Policy Committee (MPC) voted 8 to 1 for raising rates to 4% from 3.75%. However, contrary to Reuters poll predictions, the dissent came not from a committee member advocating for holding rates steady, but from one insisting on a more significant increase.
Catherine Mann, who commented last month on the BoE's slowness in calming markets regarding inflation control, voted for a half-percentage point rise to 4.25%.
In the November meeting minutes, Mann expressed concern about 'non-linear inflation risks' as consumer inflation reached 3.5% in September, which she viewed as a potential trigger for loss of confidence in the central bank.
Previously, Bailey argued that the BoE could afford to wait before deciding on a rate hike, given that at the start of the conflict, it had higher interest rates than other central banks expected, and investors had previously anticipated it would cut rates this year.
By the time of the fourth decision, investors and financial markets were almost certain of a rate hike this month. Nevertheless, financial markets also priced in a three-quarter point hike in 2027, which is more than most economists expect.
Bailey explained that such discrepancies reflect that financial markets are factoring in 'tail risks' of sharp further increases in energy prices, whereas economists' expectations are based on the most probable scenario of less further tightening.
He stated in the policy minutes: 'Without news easing risks to inflationary pressure, I see an argument for further rate hikes.' Deputy Governor Claire Lombardelli suggested that another rate hike would be needed in the near future.
External MPC member Megan Green and Chief Economist Hugh Pill, like Mann, voted for a rate hike in September, speaking of the need for 'further tightening' and 'additional hikes' respectively.
MPC members Swati Dhingra and Alan Taylor, who were previously reluctant to raise rates, stated that they would require more substantial evidence of secondary effects before supporting further tightening.
BoE Forecasts Faster Growth and Higher Inflation
In its central forecast for growth and inflation, the BoE adjusted its growth expectations for the current and next year upwards to 1.6% and 1.3% respectively, which is notably higher than what the Office for Budget Responsibility predicted last week.
This improvement followed strong official data in the current year, and the BoE links part of this growth to artificial intelligence spending, as well as a small temporary boost from Finance Minister John Healey's annual budget last week.
However, the BoE now forecasts that inflation will peak at an average of 4.8% in the second quarter of next year. In a more adverse scenario, if oil prices reach around $130 per barrel compared to the current $100, inflation will reach 6.2% in the third quarter of 2027.
According to the central scenario, inflation is not expected to return to the 2% level until the third quarter of 2028, six months later than the BoE had forecast in July when projections were made during the downturn in the US-Iran conflict, which was reducing energy costs.
The BoE reported that after accounting for inflation and taxes, the income of British households from work will decrease both in the current and next year.
The central bank added that Healey's annual budget will reduce inflation by 0.25 percentage points at its peak, but then raise it when the temporary cost of living support expires.
