LONDON — The Bank of England (BoE) on Thursday raised interest rates the most since 1989, but warned investors the risk of Britain’s longest recession in at least a century means borrowing costs are likely to rise less than expected.
The BoE hiked interest rates to 3% from 2.25% and warned that the UK economy might not grow for the next two years – the longest slump since the 1920s – if interest rates rise as much as markets recently bet .
“We can’t make any promises about future interest rates, but from today’s perspective, we believe interest rates need to rise by less than what financial markets are currently pricing in,” Gov. Andrew Bailey said in an unusually blunt message.
Sterling extended earlier heavy losses to fall nearly 2% against the dollar on the day, hitting its lowest level since mid-October as the UK recovered from a political crisis sparked by former Prime Minister Liz Truss’ tax cut plans.
On Wednesday, the Federal Reserve also hiked interest rates by 75 basis points but signaled that US borrowing costs were likely to rise more than expected in a bid to dampen inflation.
That was in contrast to the message from the British central bank on Thursday.
The BoE said it now expects inflation to hit a 40-year high of around 11% in the current quarter, more than five times its 2% target. But she also believes the economy has entered a recession, which could mean it will contract in both 2023 and 2024, contracting 2.9% overall.
Unemployment would rise steadily to 6.4% by the end of 2025, almost doubling from the current 3.5%, the lowest level since 1974.
However, these forecasts reflected market expectations from late October that interest rates would peak at 5.2%, a level the BoE had not expected on Thursday.
The BoE said the recession would be shorter if it stopped raising rates, with a quarter of positive growth midway through and a cumulative output loss of 1.7%.
The UK economy shrank by 6.3% during the 2008/09 global financial crisis.
Thursday’s rise in borrowing costs – the biggest in 33 years barring a failed attempt to support the pound on Black Wednesday 1992 – was in line with expectations by economists in a Reuters poll, but the nine policymakers disagreed.
Silvana Tenreyro and Swati Dhingra voted for smaller hikes of a quarter and half a percentage point, respectively, emphasizing headwinds from the recession.
Markets were expecting interest rates to peak around 4.7%, little changed by the BoE’s announcement.
“A moderate hike of 75 basis points should be a contradiction in terms… but that is what the BoE seems to have delivered,” said HSBC economist Liz Martins.
TURMOIL IN THE UK
Central banks across the western world are responding to similar challenges. Inflation has skyrocketed over the past year due to labor shortages and supply chain bottlenecks since the 2019 coronavirus disease (COVID-19) pandemic and – in the case of Europe – a spike in energy bills since Russia invaded Ukraine in February.
New UK Treasury Secretary Jeremy Hunt said “the government’s top priority is to get inflation under control and today the Bank took action consistent with its aim of returning inflation to target”.
The BoE has seen weeks of political and financial market chaos since its last rate hike on September 22nd.
Just a day later, Ms Truss’ government unveiled an unfunded £45 billion ($52 billion) tax cut package, which drew a scathing reaction from investors, sending sterling to record lows against the dollar and the BoE forced to prop up the bond market to help pension funds.
Mrs. Truss had to resign after 44 days in office.
Markets are now more stable and the UK government’s borrowing costs are broadly back to pre-turmoil levels. On Tuesday, the BoE was able to start selling bonds from its £838 billion quantitative easing stash.
BoE policymaking is made particularly difficult by a lack of clarity about future government policy.
While most of Ms Truss’ tax cuts have been reversed, new Prime Minister Rishi Sunak has hinted there will be a shortage of public spending and possible higher taxes, the extent of which will not become clear until a November 17 financial statement.
The BoE expects the government to continue providing energy subsidies over the next two years, but to a lesser extent after April when an existing support package expires.
The BoE projects inflation to fall below its 2% target by mid-2024, even if interest rates remain at 3%.
But Mr Bailey said inflation risks were strongly skewed to the upside and it was too risky to rule out further rate hikes.
The Monetary Policy Committee reiterated that it would respond vigorously if necessary. Next, it announces a policy decision on December 15. — Reuters