Bank of England Raises Rates the Most Since 1989 to Fight Inflation

The Bank of England’s policymakers raised interest rates on Thursday by the largest amount since 1989, intensifying their battle against inflation even as the central bank predicted that the British economy would enter a “prolonged” recession.

The bank lifted its key policy rate by three-quarters of a point, ramping up its effort to tighten financial conditions and taking the rate to 3 percent, the highest since November 2008.

It was the first meeting since the short and turbulent premiership of Liz Truss came to an abrupt end two weeks ago, which roiled financial markets.

Through all the tumult in Britain the past few months, high inflation, as well as the threat of it lingering for longer than expected, has remained a consistent scourge for the central bank. The annual inflation rate topped 10 percent in September, the highest in four decades and five times the central bank’s target.

Bank officials have said they are determined to bring inflation down to its 2 percent target and will use higher interest rates to do so. But they also sent a clear message to financial markets that the bank was unlikely to raise interest rates as high as traders had expected, which was about 5.2 percent when the bank set its forecasts in late October.

The Bank of England expects inflation to climb to about 11 percent this year, which is less than it had previously forecast because of a government plan to freeze household energy bills. While the freeze is holding down the headline inflation rate, it could add to price pressures coming from other goods and services, as households have to spend less on their energy bills, the bank said.

Early next year inflation is expected to be around 10 percent, the bank said, and later drop sharply as the global forces driving up inflation, such as energy costs and supply chain bottlenecks, diminish.

The bank’s latest projections “described a very challenging outlook for the U.K. economy,” policymakers said, according to the minutes of their meeting this week. “It was expected to be in recession for a prolonged period.”

After the announcement, government bonds extended their decline and the pound slumped against the dollar, exacerbating moves that began in response to the Federal Reserve’s interest rate increase late on Wednesday. The yield on 10-year British government bonds rose 10 basis points, to about 3.5 percent. The British pound was down 2 percent in daily trading.

Having barely recovered from the pandemic, Britain’s economic growth is faltering again as rising energy bills, food costs and mortgage rates squeeze consumer spending, stalling one of the key drivers of the country’s economy.

The bank forecast that the economy would shrink by 0.75 percent in the second half of 2022, and would keep falling next year and the first half of 2024 because of high energy prices and “materially” tighter financial conditions, including higher home mortgage rates and borrowing costs for companies. This two-year recession is based on the assumption that the central bank raises interest rates in line with market expectations. While the bank has pushed back on those expectations, it said that even if interest rates didn’t rise again the economy was still set to record a decline for the second half of this year and much of next year.

This outlook could temper how much higher the bank raises rates. That’s because it takes time for rate changes to have an impact on the economy, and that impact is likely to hit Britain while it is in a recession, when households and businesses are least able to bear the additional economic pain.

This lag is a challenge for many central banks, which are also raising interest rates quickly in the face of the highest inflation in decades and potential recessions. On Wednesday, the Federal Reserve raised rates by three-quarters of a percent and signaled that more increases were to come, though the pace of them would slow. Last week, the European Central Bank raised rates by three-quarters of a point as it said inflation could increase, but the bank heavily stressed that the economy was weakening.

In Britain, there have been “significant developments” in fiscal policy since the bank’s last policy meeting six weeks ago, Thursday’s statement said. The day after the previous meeting, on Sept. 23., Ms. Truss’s finance minister, Kwasi Kwarteng, announced a series of unfunded tax cuts that provoked turmoil in the government bond market and set Britain’s fiscal policy on a collision course with the bank’s monetary policy.

At the time, the central bank said it would need to have a “significant” response as it expected the tax cut and spending plan to add to inflationary pressures. Meanwhile, in another corner of the bank, officials intervened in the bond market, fearing for the country’s financial stability.

Two weeks ago, Ms. Truss resigned, and her successor, Rishi Sunak, has made it clear that he intends to take a different approach to public finances. Later this month, he and the chancellor of the Exchequer, Jeremy Hunt, are expected to announce tax increases and spending cuts alongside a plan to cut Britain’s debt levels.

Still, on Thursday the bank said that the fiscal measures that have been announced so far — including freezing energy bills, abolishing a health and social care tax, and reducing taxes on house purchases — would bolster demand more than the bank forecast three months ago.

Seven of the bank’s nine-person rate-setting committee, including the governor, Andrew Bailey, voted for the three-quarter point increase in interest rates. The two others voted for a half-point and quarter-point increase each, arguing that the cost-of-living crisis warranted caution against over-tightening, and that monetary policy was already restrictive.

Britain’s outlook remains gloomy and uncertain. A plan to freeze energy bills that took effect last month and helps hold down the headline inflation rate will last only until the end of March. Even with this measure, average energy bills are about twice as high as last winter, food inflation is at its highest in four decades and many households are looking ahead to sharp increases in their mortgage payments. With customers aiming to reduce spending, corporations are warning about lower profits, and many companies and services are facing disruption from ongoing labor disputes. Meanwhile, the labor market remains tight with more people than expected staying out of work, including because of long-term sickness.

Overall, the bankpredicted that household income, after accounting for taxes and inflation, would fall 0.25 percent this year and 1.5 percent next year.

Among the causes for concern are rising mortgage payments. About 30 percent of British households have a mortgage, and while the majority of these are on fixed rates, they tend to have short terms, such as two and five years. The bank said a quarter of mortgages, just over two million, were scheduled to reach the end of their fixed term by the end of next year, which would raise mortgage costs “significantly” for those households.

The squeeze on incomes from high inflation and higher mortgage rates are “expected to weigh on household spending for some time,” the bank said. “Despite fiscal support, the energy price shock remains significant.”