Bank of England Raises Interest Rate by Half a Percentage Point to Tackle High Inflation

The Bank of England (BOE) made a bold move by increasing its key interest rate by half a percentage point, reaching 5%, the highest level since April 2008. This decision reflects the central bank's determination to address the highest inflation rate among the Group of Seven wealthy countries.

However, concerns have emerged that such a significant rate hike might push the UK economy into a recession later this year as efforts to curb price increases intensify.

Central banks worldwide have been grappling with the challenge of taming inflation, which has proven more persistent than initially anticipated. On the same day, Norway's central bank raised its core lending rate by 0.5%, and Switzerland increased its benchmark rate by 0.25%. Both banks warned of further rate hikes in the coming months.

Recently, the European Central Bank, the Bank of Canada, and the Reserve Bank of Australia raised rates by 0.25%, signaling a trend of increasing borrowing costs. The Federal Reserve, while keeping its key rate unchanged, indicated its intention to continue raising rates.

This shift in monetary policy represents a reassessment of previous expectations, signaling an acceleration rather than a slowdown. The actions taken by the BOE, the Bank of Canada, and Norges Bank serve as a reminder that the global economic situation might necessitate further responses. Analysts and investors are now considering this a wakeup call.

The UK has been particularly challenged by stubborn inflation rates. May's consumer price data, released on Wednesday, showed a year-on-year increase of 8.7%, unchanged from April. Economists and investors had initially expected a 0.25% interest rate increase from the BOE before the inflation figures were revealed.

BOE Governor Andrew Bailey emphasized the need to address high inflation, stating that the current levels remain too high and must be dealt with promptly. Recognizing the difficulty of the situation, Bailey warned of the potential consequences if rates are not raised now, suggesting that they could worsen in the future.

Unlike the United States and the eurozone, where core inflation has been declining, the UK's core inflation measure, excluding volatile items like food and energy, reached its highest level in over three decades. The surge in services inflation has been a key focus for the BOE, as it closely monitors signs of rising wages leading to increased prices—a phenomenon known as a wage-price spiral.

Seven out of nine rate setters at the BOE agreed that a stronger response was necessary during this specific meeting due to indications that inflation will remain high for a more extended period than anticipated. The BOE indicated the possibility of further interest rate hikes in the coming months if fresh signs of prolonged high inflation persist.

Following the BOE's decision, the FTSE 100 index experienced a decline, dropping 1.2% on the day. The UK's 10-year government bond yield also fell to 4.343% from 4.406%, while the pound showed some volatility against the dollar.

Since the surge in energy and food prices caused by Russia's invasion of Ukraine in early 2022, the UK economy has struggled to maintain growth. Although the BOE had anticipated a recession during the winter, it revised its growth forecasts in May, noting that the economy had proven more resilient than expected. However, economists express concerns that a sharp increase in borrowing costs, combined with higher energy and food prices, could push the UK into a contraction.

The impact of higher interest rates is particularly felt by UK homeowners. Unlike the US, where mortgage rates are fixed for extended periods, British mortgages typically carry fixed interest rates for two to five years. As a result, more households face significantly higher interest payments. The Institute for Fiscal Studies estimates that higher interest payments will reduce the disposable income of households with mortgages by over 8%.

Tom Wernham, an economist at the Institute for Fiscal Studies, warns that the increase in monthly mortgage repayments will come as a serious shock to many homeowners.

Muhammad Zahidi, a homeowner in northwest London, experienced a rise in mortgage payments from £1,600 to £2,100 per month, with the expectation of further increases as rates climb. To cope with the escalating mortgage costs, Zahidi has rented out his property and is currently living with his parents. He expresses his worry about the rising rates, considering it a concerning sign.

While British government officials understand the immediate impact of higher interest rates on households, they stress the importance of tackling inflation to prevent further difficulties in the future. They argue that sticking to their strategy and bringing inflation down is crucial to relieve the pressure on families with mortgages. They believe that postponing action would only worsen the situation.

British Prime Minister Rishi Sunak has pledged to reduce inflation to around 5% by the end of the year, acknowledging the challenges ahead and the necessity for difficult decisions to be made promptly.

Within the BOE, two policymakers voted to keep rates on hold, asserting that the central bank had already taken the necessary actions to achieve its 2% inflation target.

Compared to the Federal Reserve and the European Central Bank, the Bank of England has been raising its key interest rate for a more extended period. Since December 2021, the BOE's cumulative rate increase slightly exceeds that of the Federal Reserve and is one percentage point higher than that of the European Central Bank.

In its last forecast, the BOE predicted that inflation would reach its target of 2% by the end of 2024, approximately nine months later than anticipated earlier in the year. Investors now expect the BOE's key interest rate to average 5.5% over the next three years, up from the 4% projected during its May meeting.

Amid growing concerns and calls for accountability, British lawmakers are seeking an independent review of the BOE's inflation forecasts to understand what went wrong and assess the situation more effectively.