The Bank of England has raised its interest rates to 5.25% for the 14th consecutive time, warning businesses and households that borrowing costs will remain high for at least the next two years.

The decision to increase rates by 0.25 percentage points is in response to strong wage growth in recent months and brings the interest rate to its highest level in 15 years.

Optimistic signs

Despite the interest rate hike, policymakers are confident in ruling out the likelihood of a recession over the next two years. They have noted that the economy has shown more resilience than expected during this period of elevated interest rates, as assessed in May.

The Bank of England expects energy prices to fall later in the year, which should help bring inflation down below 5% in the fourth quarter. This aligns with the government’s goal to halve inflation by the end of 2023 from its peak of 10.5% earlier in the year.

However, the Bank has identified two persistent barriers to reducing inflation further. First, strong demand for workers is pushing wages higher, and secondly, the cost of services has only recently reached a peak, contributing to ongoing inflationary pressures.

As of June, the Consumer Prices Index (CPI) has declined to 7.9% from the previous month’s 8.7%. Meanwhile, the latest labour market data shows average wage rises standing at 7.7%.

Bank of England comment

The Bank of England’s governor, Andrew Bailey, supports the quarter-point increase in interest rates, expressing confidence that inflation is on track to fall towards the target of 2%. The primary aim of raising rates to 5.25% is to ensure inflation falls back to the 2% target, thereby alleviating its impact on the most vulnerable segments of society.

Bailey revealed that they expect the annual rate of price rises to decline to around 7% in July, with a further drop to about 5% in October. The decision to raise interest rates had a three-way split among the Monetary Policy Committee (MPC), with two members voting for a steeper 0.5% increase due to under-predicted inflationary pressures.

Despite the rise in interest rates from 0.1% in 2021, the Bank believes it is necessary to keep borrowing costs restrictive for an extended period to bring inflation back to its target level. As a result, interest rates may remain above 5% into the following year and even through 2025.

Earlier this year, Bailey faced criticism when the Bank’s forecasts of a prolonged recession were proven wrong, as the economy showed growth instead. Current forecasts indicate moderate economic expansion over the next three years, but by less than 1%. The recent rate hikes and the indication of prolonged high rates are expected to suppress GDP growth by an additional 0.75 percentage points by 2026, preventing the UK economy from surpassing its pre-pandemic size.

Consumer spending is predicted to increase as households draw down their savings. However, the economy will be restrained by a 6% decline in housing investment and flat business investment spending since the Brexit vote in 2016.

Inflation to be halved?

Prime Minister Rishi Sunak’s aim of halving inflation by the end of the year is expected to be achieved by a narrow margin. The Bank forecasts CPI to fall to 4.9% in the fourth quarter, down from an average of approximately 10% in the second half of 2022.

The last time interest rates were above 5.25% was in January 2008, with some calls for rate cuts at that time to avert a recession. In May, the Bank’s outlook suggested rates would peak at about 4.75% in the fourth quarter of this year and then gradually decline over the next 18 months to 3.5%.

Unemployment, which was previously projected to remain below 4% until the end of 2024, is now expected to rise to nearly 5%. However, the Bank believes there won’t be a significant increase in distressed mortgage holders defaulting on their home loans.

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