The Bank of England presented a bleak outlook for the British economy on Thursday, predicting a long recession to begin later this year due to the impact of high inflation. But the central bank stepped up its efforts to tackle rising prices as it raised interest rates by half a percentage point, the biggest jump since 1995.
The bank raised its benchmark rate to 1.75 percent, the highest since 2008, as it forecast the annual inflation rate to rise above 13 percent as energy bills from households increase in October. That would be the highest level of inflation in 42 years and six times the bank’s 2 percent target.
Much of the price increase still comes from the global energy market, the bank said. In the past three months, wholesale natural gas prices for this winter have almost doubled, which the bank predicted would raise the cap on household energy bills to 3,500 pounds (about $4,245) in autumn, three times the amount of a year ago.
The outlook for millions of British households is bleak. Incomes, adjusted for inflation and taxes, are expected to fall sharply this year and next, in the worst decline on record since the 1960s.
Britain, the world’s fifth-largest economy, will enter a recession in the final quarter of this year that will last until 2023, the bank forecasts, the same length of recession after the financial crisis of 2008.
“The latest rise in gas prices has led to another significant deterioration in the outlook for activity” in the UK and the rest of Europe, policymakers said, according to minutes of this week’s meeting. “Britain is now set to go into recession.”
The rate change announced on Thursday was the sixth increase since December as the bank tries to tackle inflation, which is running at its fastest pace in four decades. It has come under some pressure to raise rates by more than its usual quarter-point move as inflationary pressures persist and other major central banks take more aggressive steps to curb price increases.
The Bank of England was the first major central bank to start raising rates in response to global inflation while easing monetary policies that supported the economy during the pandemic. The European Central Bank raised interest rates last month for the first time in more than a decade. And in the United States, the Federal Reserve raised rates last week by three-quarters of a percentage point for the second month in a row.
There is little that banks can do to curb energy prices or ease supply chain disruptions, but their aim is to ensure that rapid price increases do not last too long, causing consumers and companies are more expensive to borrow money. So far, unemployment has remained generally low in the United States, the European Union and Britain, but the risk is that by trying to reduce inflation, policymakers will trigger deep recessions and layoffs. The International Monetary Fund warned last month that there could be a global recession.
Global inflation has been exacerbated by the war in Ukraine and Western sanctions on Russia, which have further disrupted supply chains and driven up the cost of energy.
“There is an economic cost to war,” Andrew Bailey, the bank’s governor, said Thursday. “But that will not divert us from setting monetary policy to bring inflation back to the 2 percent target.”
In the United Kingdom, consumer prices rose 9.4 percent in June from a year earlier, faster than inflation in the United States and the euro zone.
The National Institute for Economic and Social Research, a London-based think tank, said on Wednesday that the economy was entering recession this quarter and would lose 1 percent of gross domestic product in three quarters.
“We’re really stuck here,” Stephen Millard, the research institute’s deputy director, said before the bank’s decision.
As high inflation meets recession, household incomes are squeezed because wage growth is not keeping pace with rising prices. The research institute has called for more government support for low-income households as food prices continue to rise and households energy bills jump, perhaps as much as 75 percent in the fall.
The Bank of England’s own forecasts are even more gloomy. Next year, the economy will contract by 1.5 percent, he predicted, assuming no change in fiscal policy. It shows the scale of the economic challenge facing the two Conservative lawmakers who are fighting for the party leadership and the role of prime minister. Much of the debate so far has focused on taxes, with front-runner Liz Truss promising to cut them quickly for workers and businesses amid a cost-of-living crisis.
Ms. Truss has also said he would reassess the government’s bank mandate to ensure price stability, to ensure that it “matches some of the most effective central banks in the world at controlling inflation.” The central bank has been independent of the Treasury since 1997, but the government still sets the inflation target. Ms. Truss added that the mandate was long overdue.
Mr. Bailey avoided being drawn into speculation about a new term at a news conference on Thursday. “I’m not going to comment on anything the Conservative Party leadership candidates have said,” he said.
Even as the economic outlook worsens, the central bank has emphasized its main goal of reducing inflation. Eight of the nine members of the rate-setting committee voted in favor of the outsized move amid signs that inflationary pressures were becoming more persistent and emerging in more parts of the economy.
“The combination of high short-term inflation and weak activity leading to a recession is a challenging context for monetary policy,” but the focus should remain on inflation and inflation expectations, he said Bailey.
The inflation outlook has deteriorated rapidly. In December, when the bank raised rates for the first time, it predicted that inflation would peak at 6 percent in April. Now that peak is six months later and more than double. Rising energy prices are the main reason for the rapid inflation, the bank said, but supply chain disruptions and domestic inflationary pressures are also rising.
Consumer services inflation, which is much less affected by the overall price of goods, rose 5.2 percent in June from a year earlier, the highest since early 1993. The tight labor market it is also driving inflation. Unemployment is low and job vacancies are high, so underlying wage growth is picking up as employers compete to hire and retain staff. Meanwhile, companies are passing on a larger share of their cost increases to their customers.
While some contributors to inflation are showing signs of easing, such as global commodity prices, policymakers took only limited comfort from these signs. There is a risk that a longer period of inflation driven by external factors such as global energy prices and pandemic-related supply chain disruptions will lead to “longer” price and wage pressures in house, according to the record. This was one of the reasons for the larger than usual increase in interest rates.
There are “exceptionally large” risks around the bank’s economic and inflation forecasts, Bailey said. But inflation should fall back towards the bank’s target in two years, depending on financial markets’ expectations about the future path of interest rates. As the bank drew up its forecasts, markets expected rates to rise to 3 percent in the first half of next year and then fall.
Policymakers are likely to raise rates more cautiously than markets expect because the dominant force pushing up prices, the cost of natural gas, is beyond the control of monetary policy, said Martin Beck, economic adviser to ‘EY, in a note to clients. These higher energy prices will eventually reduce demand and therefore cause prices to fall, he added.
While the bank is using higher interest rates as its main tool to curb inflation, at bottom it is also reversing one of its main policies that helped support the economy during the pandemic: the purchase of good ones As of December, the bank increased its holdings in British government bonds to 875 billion pounds, but has since stopped reinvesting proceeds from maturing bonds, allowing its balance sheet to shrink.
Next month, he hopes to take a step he has never taken before and start selling bonds back into the market. It expects to sell about 10 billion pounds of bonds each quarter in the first year, if market conditions are right and policymakers vote to start the process.
With so much uncertainty about the economy and prices, the bank offered fewer clues about the future path of interest rates, stressing, as other central banks have done recently, that it will base its decisions on the latest data.
“Politics is not on a predetermined path,” the minutes said.