The Bank of England has warned businesses and households that the cost of borrowing will remain high for at least the next two years as it raised interest rates for the 14th consecutive time to 5.25%.
Ruling out the likelihood of a recession over the next two years, policymakers blamed strong wages growth in recent months for the need to increase interest rates by 0.25 percentage points to the highest level for 15 years.
In a three-way split on the Bank’s nine-strong monetary policy committee (MPC), officials said the economy had proved more resilient during a period of high interest rates than they expected when they last made an assessment of the UK economy in May.
Energy prices were expected to fall over the rest of the year, bringing inflation down below 5% in the fourth quarter, allowing the government to declare a victory in its mission to halve inflation by the end of 2023 from a peak of 10.5% at the start of the year.
However, the Bank said strong demand for workers, which is pushing wages higher, and a rise in the cost of services that has only just reached a peak were proving a persistent barrier to bringing down inflation.
The consumer prices index fell in June to 7.9% from 8.7% in the previous month, while the latest labour market data showed average wage rises stood at 7.7%.
Two members of the MPC voted to increase interest rates by a sharper 0.5% following a succession of forecasts that had “under-predicted” inflationary pressures and the possibility that the latest outlook would repeat the error.
Swati Dhingra, an economist seconded to the MPC from the London School of Economics, voted to keep rates on hold, arguing that the effects of previous interest rate rises had yet to work their way through to household and business finances and should be allowed more time to dampen spending.
The Bank’s governor, Andrew Bailey, who backed the quarter-point increase, said the MPC’s efforts meant inflation was on course to fall towards its 2% target.
“Inflation is falling and that’s good news. We know that inflation hits the least well-off hardest and we need to make sure that it falls all the way back to the 2% target. That’s why we’ve raised rates to 5.25% today,” he said.
According to the minutes of the MPC meeting, the steep rise in interest rates from 0.1% in 2021 was restricting spending in the economy and helping to bring down inflation, but policymakers added that they they would ensure the cost of borrowing “was sufficiently restrictive for sufficiently long to return inflation to the target”, indicating interest rates might remain above 5% next year and into 2025.
Bailey came under fire earlier this year after the Bank was forced to tear up forecasts of a long recession this year and next after data for gross domestic product (GDP) showed the economy avoided a contraction.
The latest forecasts show the economy expanding over the next three years, but by less than 1%. The latest rate rises and the indication that rates will remain high for the next two years are expected to dampen GDP growth by a further 0.75 percentage point by 2026 and likely prevent the UK economy expanding by more than its pre-pandemic size.
Consumer spending is forecast to expand as households run down their savings, but the economy will be held in check by a 6% fail in housing investment and a continuation of flat business investment spending that dates back to the Brexit vote in 2016.
Sunak is expected to meet his aim of halving inflation by the end of the year by the smallest of margins. The Bank said CPI would fall to 4.9% in the fourth quarter, down from an average of about 10% in the second half of 2022.
The last time interest rates were above 5.25% was in January 2008 when it was 5.5%. At the time there were calls for the central bank to cut rates to prevent a recession.
In May, the Bank based its outlook on interest rates peaking at about 4.75% in the fourth quarter of this year before falling over the next 18 months to 3.5%.
The unemployment rate was projected in May to remain below 4% until the end of 2024, before rising over the second half of the forecast period to around 4.5%. Unemployment is now expected to increase to almost 5%, though the Bank said there was unlikely to be a significant rise in distressed mortgage payers defaulting on home loans.
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