The Bank of England (BoE) raised its key interest rate to 2.25% from 1.75% on Thursday and said it will continue to “respond strongly as necessary” to inflation, even as the economy heads into recession.
The BoE estimates that the British economy will shrink 0.1% in the third quarter — partly due to the extra holiday for Queen Elizabeth’s funeral — which, combined with a drop in output in the second quarter, meets the definition of technical recession.
Economists polled by Reuters last week were predicting a repeat of August’s 0.5 percentage point rate hike, but financial markets were betting on a 0.75 percentage point increase, which would be the largest since 1989, apart from a brief, failed attempt in 1992 to prop up the pound.
The pound fell more than half a cent against the U.S. dollar after the decision and was below $1.13 after hitting a 37-year low near $1.12 earlier in the day. Prices of British government bonds fell sharply.
The BoE’s move comes after the US Federal Reserve’s decision on Wednesday to raise its key rate by 0.75 percentage point as central banks around the world deal with post-Covid labor shortages and the impact of Russia’s invasion of Ukraine on energy prices.
The BoE’s monetary policy committee voted 5-4 to raise rates to 2.25%, with two members voting for an increase to 2.50% and another advocating a lower tightening to 2%.
Financial markets now see an approximately 75% chance that the BoE will raise the bank rate again to 2.75% at its next meeting in November. Prior to the decision, a rate of 3% was fully priced in.
The BoE now expects inflation to peak at just under 11% in October, down from the 13.3% peak forecast last month before Liz Truss won the Conservative Party leadership and became UK Prime Minister on a promise to cap energy tariffs and cut taxes.
Inflation will remain above 10% for a few months after October before falling, the BoE said.