Bank of England set to raise UK interest rates to 1.75%

·6 min read
Interest rates Governor of the Bank of England Andrew Bailey addresses the media on the Monetary Policy Report at the Bank of England in London, Britain May 5, 2022. Frank Augstein/Pool via REUTERS
Governor of the Bank of England Andrew Bailey will explain the interest rate decision at midday this Thursday. Photo: Frank Augstein/Pool via Reuters

The Bank of England (BoE) has made it clear that it will act forcefully to rein in record high inflation and markets are all but certain that a rare half-percentage point interest rate rise will be delivered this Thursday.

The 50 basis points increase to 1.75% will be the biggest interest rate in 27 years and accelerate a historic tightening of monetary policy to choke off the highest level of inflation in 40 years.

Inflation hit 9.4% in June and the Bank of England is expecting it to peak to 11% before the end of the year — well above its 2% target.

Inflation is at a record high
Inflation is at a record high. Chart: Yahoo

The BoE has raised interest rates in 0.25 percentage point increments since December but pledged in June to act “forcefully” if needed in response to more persistent inflationary pressures.

“The Committee will be particularly alert to indications of more persistent inflationary pressures, and will if necessary, act forcefully in response. Bringing inflation back down to the 2% target sustainably is our job, no ifs or buts”, BoE governor Andrew Bailey said.

Matthew Ryan, head of market strategy at Ebury, said it will be difficult for the Monetary Policy Committee (MPC) to buck the hawkish trend among G10 central banks and therefore predicts a 50 basis point hike.

“Interest rate markets were largely, though not fully, pricing in a 50 basis point move, with some investors betting on a 25bp hike,” he said.

Read more: How Bank of England’s interest rate rise will affect mortgages and house prices

“Therefore, it is a solid bet that Thursday trading will be volatile. We think it will be difficult for the MPC to buck the hawkish trend among G10 central banks and expect the larger move, with a consequent rally in sterling as a side effect.

“This rally may, however, be dependent on the voting pattern among policymakers, and the tone of communications in the bank’s latest inflation report.”

The BoE has increased interest rates for a record fifth time in a row in seven months so far. The rate rises are taking money out of people’s pockets by increasing borrowing costs.

UK interest rates
UK interest rates. Chart: Yahoo

Investors see an 82% chance of a bigger-than-usual, half-percentage-point rate hike by the BoE this Thursday.

Daniela Hathorn, market analyst at IG, said Bailey and his colleagues will have the US Federal Reserve's latest move weighing over them.

“Last Wednesday’s cautious tone from the Fed will have likely resonated to some extent with the BoE’s MPC. That’s not to say the Fed was all caution, as they were still very stern about combating inflation and continuing its rate hiking cycle, but the more cautious BoE is likely to be outweighing concerns about the economy."

The Fed raised rates a total of 1.5 points at its past two meetings. The European Central Bank (ECB) raised its three key interest rates by 50 basis points to combat runaway inflation.

Peder Beck-Friis, portfolio manager at PIMCO, expects a 50 basis point but wouldn’t be surprised if the interest rate only moved by 25 basis points.

Read more: How interest rate rises are affecting UK mortgages

“We expect a +50bps hike on Thursday. At the last meeting, the BoE said that it would act ‘forcefully’ if there were signs of persistent inflationary pressures. We think incoming data (accelerating wages, rising services inflation) have supported this, though we acknowledge there is a good chance the BoE chooses to continue at a +25bps pace.

“The weakening growth outlook and falling inflation expectations will likely persuade some MPC members to stick with a +25bps vote. An outsized +75bps hike is very unlikely, in our view.”

The IMF pointed to the UK as one of the countries where the outlook for inflation had worsened most.

A survey of UK households by S&P revealed that expectations are hawkish. The proportion of households expecting the UK’s central bank to hike interest rates in the next three months ticked up from 56% in June to 60% in July. This was the second-highest reading since data collection began nine years ago, behind only the series peak registered in May.

“It’s clear that households are bracing for a further rise in borrowing costs and are expecting the central bank to continue their efforts to tackle inflationary pressures against the backdrop of a severe cost of living crisis,” Lewis Cooper, economist at S&P Global Market Intelligence said.

Read more: Bank of England's Bailey signals UK interest rates rising to 1.75% in August

“Households' expectations again aligned with financial markets that continue to price in further base rate hikes this year. The recent aggressive tightening by the US Federal Reserve will further add to calls for the Bank of England to follow suit in their August meeting. Another rate hike would come in the context of a weakening economic picture for the UK, however, with Flash PMI business survey data for July showing the rate of growth slowing to a crawl.”

Despite the BoE’s pledges to bring down inflation, Threadneedle Street has to walk a fine balance between relentless inflationary pressure and the rising risk of recession.

The National Institute of Economic and Social Research (NIESR) said the central bank was slow to act against inflation and that now it needs to keep raising rates to maintain credibility. The think tank sees the bank rate reaching 3% in the second quarter of next year.

Deutsche Bank is also banking on a higher-than-usual rate hike this Thursday, despite the risk of an economic slowdown or a recession.

Sanjay Raja, senior economist at Deutsche Bank, said: “We expect the BoE to lift rates by 0.5pp in August — taking the Bank Rate to 1.75%. This would mark the largest single Bank Rate increase since 1995, and the biggest step increase since the Bank's independence.

Read more: Bailey: Bank of England will bring inflation down ‘no ifs or buts’

“However, as has been the case throughout the tightening cycle, we do not expect the August decision to be unanimous. We expect a 7-2 vote with two dissenters opting for a smaller 25bps hike,” he added.

If the BoE follows though with raising the central bank’s benchmark rate to 1.75% it will be the sharpest increase in borrowing costs for more than a quarter of a century.

The last time the BoE raised interest rates by 50 basis points was in February 1995, when the government set the cost of borrowing with advice from the central bank.

The BoE’s decision is due to be announced at midday on Thursday 4 August.

Watch: How does inflation affect interest rates?