The Bank of England is raising rates by the most since 1989 to fight inflation

The Bank of England is raising rates by the most since 1989 to fight inflation

Bank of England policymakers raised interest rates on Thursday by the most since 1989, intensifying their fight against inflation even as the central bank predicted Britain’s economy would enter a “prolonged” recession.

The bank raised its benchmark interest rate by three-quarters of a point, stepping up its efforts to tighten financial conditions and raising the rate to 3 percent, the highest since November 2008.

It was the first meeting since Liz Truss’ short and turbulent Prime Ministership was abruptly ended two weeks ago, sending financial markets into a tailspin.

With all the turmoil in Britain over the past few months, high inflation, and the threat of it lingering longer than expected, has remained a constant scourge for the central bank. The annual inflation rate exceeded 10 percent in September, the highest in the last four decades and five times higher than the central bank’s target.

Bank officials said they are determined to bring inflation down to the 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 were around 5.2 percent when the bank set its forecasts in late October.

The Bank of England expects inflation to rise to around 11 percent this year, lower than it had previously forecast because of the government’s plan to freeze household energy bills. While the freeze keeps headline inflation in check, it could increase price pressures coming from other goods and services as households have to spend less on their energy bills, the bank said.

Inflation is expected to be around 10 percent early next year, the bank said, and will fall sharply later as global inflation-promoting forces such as energy costs and supply chain bottlenecks ease.

The bank’s latest projections “paint a very challenging outlook for the UK economy”, policymakers said, according to minutes of a meeting this week. “It was expected to be in recession for an extended period.”

After the announcement, government bonds extended their slide and the pound weakened against the dollar, worsening moves that began in response to the Federal Reserve’s interest rate hike late Wednesday. The yield on 10-year British government bonds rose 10 basis points to around 3.5 percent. The British pound fell 2 percent in intraday trading.

After barely recovering from the pandemic, Britain’s economic growth is once again faltering as rising energy bills, food costs and mortgage rates reduce consumer spending, halting one of the key drivers of the country’s economy.

The bank forecast that the economy will shrink by 0.75 percent in the second half of 2022, and that it will continue to decline next year and the first half of 2024 due to high energy prices and “materially” tighter financial conditions, including higher mortgage and borrowing rates. costs for companies. This two-year recession is based on the assumption that the central bank raises interest rates in line with market expectations. Although the bank scaled back those expectations, it said that even if interest rates do not rise again, the economy will still contract in the second half of this year and most of next year.

This outlook could moderate how much more 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’s in recession, when households and businesses are least able to withstand additional economic pain.

This lag presents a challenge for many central banks, which are also rapidly raising interest rates in the face of the highest inflation in decades and a potential recession. On Wednesday, Federal Reserve raised rates by three-quarters of a percent and signaled that more hikes are to come, although their pace will slow. Last week, European Central Bank raised rates by three-quarters of a point as it said inflation could rise, but the bank strongly emphasized that the economy was weakening.

There have been “significant developments” in fiscal policy in Britain since the bank’s last policy meeting six weeks ago, it said in a statement on Thursday. A day after the previous meeting, on September 23, Mrs Truss’ finance minister, Kwasi Kwarteng, announced a series of unfunded tax cuts that sent the government bond market into turmoil and brought Britain’s fiscal policy into collision with the monetary policy bank.

The central bank said at the time that it would have to have a “significant” response as it expected the tax cuts and spending plan to add to inflationary pressures. Meanwhile, in the other 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 made it clear he intended 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 along with a plan to reduce Britain’s debt levels.

Still, the bank said on Thursday that the fiscal measures announced so far – including freezing energy bills, scrapping health and social care taxes and cutting tax on house purchases – will boost demand more than the bank predicted three months ago.

Seven members of the bank’s nine-member rate-setting committee, including Governor Andrew Bailey, voted to raise interest rates by three-quarters of a point. The other two voted for a half and a quarter point increase, arguing that the cost-of-living crisis warranted caution against excessive tightening and that monetary policy was already restrictive.

Britain’s outlook remains bleak and uncertain. A plan to freeze energy bills that came into effect last month and is helping to keep headline inflation in check will only last 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 expecting a sharp increase in their mortgage payments. As customers look to cut spending, corporations are warning of lower profits, and many businesses and services are facing disruptions due to ongoing labor disputes. Meanwhile, the labor market remains tight with more people than expected out of work, including due to long-term illness.

Overall, the bank predicted that household incomes, after accounting for taxes and inflation, would fall by 0.25 percent this year and 1.5 percent next year.

Among the reasons for concern are rising mortgage payments. Around 30 per cent of UK households have a mortgage, and while most of these are fixed-rate, they tend to have short terms, such as two and five years. The bank said that a quarter of mortgages, just over two million, should reach the end of their fixed term by the end of next year, which would “significantly” increase mortgage costs for those households.

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

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