Bank of England poised to raise rates after inflation shock

LONDON  – The Bank of England is set to raise interest rates for a 13th time in a row on Thursday, a day after inflation data came in higher than expected again, with investors split on just how big the new hike will be.

Economists polled by Reuters last week were unanimous that the BoE would raise rates to 4.75 percent, their highest since 2008, from 4.5 percent.

But after inflation held at 8.7 percent in May, financial markets priced in a nearly 50 percent chance that the BoE would opt for a bigger move and raise rates by half a percentage point.

READ: UK borrowers brace for more expensive loans as inflation fails to fall as anticipated

“I think it’s a very finely balanced decision,” said Tomasz Wieladek, chief European economist at U.S investment firm T. Rowe Price, who predicts at least three of the Monetary Policy Committee’s nine members will vote for a half-point hike.

Britain’s economy, which has been hit by the shock of Brexit as well as the COVID-19 pandemic and the surge in gas prices caused by Russia’s invasion of Ukraine, has dodged a widely expected recession so far in 2023 though growth looks set to be a minimal 0.25 percent this year, according to the BoE’s forecasts.

READ: IMF says UK no longer heading for a recession in 2023

Unlike most other big rich economies, output has barely recovered to pre-pandemic levels. However, two inflation readings since the BoE’s last rate hike in May have both been higher than expected, raising fears that Britain faces a more persistent price growth problem than the United States or the euro zone.

Households are now also seeing their mortgage bills rise, with average new two-year fixed-rates rising to 6.15 percent on Wednesday in anticipation of further rate hikes.

Financial markets were estimating that the BoE would keep raising rates until they hit 6 percent – their highest since 2001 – more than the U.S. Federal Reserve which is seen tightening by just a quarter point more and the European Central Bank which investors expect may move twice more.

“The UK has a uniquely bad inflation problem,” Krishna Guha, a vice chairman at U.S. investment banking advisory firm Evercore, said.

Prime Minister Rishi Sunak – who has pledged to halve inflation this year in an attempt to win back voter support ahead of a national election expected in 2024 – has said he fully backs the BoE’s efforts to tame prices.

However, Sky News said on Wednesday that unnamed members of the government thought Governor Andrew Bailey was failing at his job.

Falling faster?

The central bank last month forecast that consumer price inflation, which peaked at a 41-year high of 11.1 percent in October 2022, would fall to just over 5 percent by the end of this year and be below its 2 percent target in early 2025.

A significant inflation drop is almost inevitable as energy prices come down from last year’s peaks.

But incoming BoE policymaker Megan Greene – who will join the MPC next month – said last week that getting inflation from 5 percent to 2 percent may prove a tougher task than the initial fall.

Core inflation – which strips out more volatile prices to show an underlying trend – rose to a 31-year high in May.

Wieladek, who worked at the BoE from 2008 to 2015, said wages looked set to keep on growing at an annual rate of around 6 percent, almost twice the level consistent with 2 percent inflation, given the shortage of workers available to many employers.

In previous decades, British wage growth has only slowed after a large rise in unemployment, and Wieladek estimated the BoE would need to engineer a recession that pushed unemployment up to 6 percent-6.5 percent from its current 3.8 percent to achieve this now.

“Unfortunately, the Bank of England is in a situation where they will have to hike until something breaks,” he said.

Most economists are less gloomy and think rates are more likely to peak near 5% as recent falls in energy and raw material costs affect the price of other goods and services.

“Market pricing for a lot more rate hikes could reverse quite quickly – especially if weaker inflation is ultimately allied with easing wage pressures,” strategists at Nomura wrote.