BoE raises rate to 1% as recession risks mount

The Bank of England increased the policy rate by 25 basis points to 1% today (May 5), as it warned inflation is likely to rise above 10% this year, the highest rate since 1982. 

It marks the first time the Bank of England has raised interest rates four times in a row since its foundation in 1694. 

The UK has met with a succession of shocks, which “monetary policy was unable to prevent”, said governor Andrew Bailey. Most recently, Russia’s invasion of Ukraine has triggered a surge in energy prices.

The monetary policy committee vote was split 6–3. The three dissenters, Jonathan Haskel, Catherine Mann and Michael Saunders, preferred to raise the policy rate by 50bp. They believed faster policy tightening now would help to bring back inflation to the target sustainably in the medium term.

But policy-makers face a difficult trade-off, as the UK economy could now be facing recession. The BoE’s updated forecasts showed GDP growth is expected to slow to around 0% next year. 

The central bank avoided using the term ‘recession’ to describe the outlook, but much depends on the assumptions behind its forecasts. 

Its projections based on market interest rate expectations imply a 51–63% chance of negative GDP growth in three consecutive quarters, from Q1 to Q3 2023, if other policy measures remain unchanged. 

However, should the policy rate remain constant at 1%, the odds of negative growth in any of the three quarters falls substantially, to 33–47%. 

Asked why the BoE had raised the interest rate when the UK could be heading for recession, Bailey said on balance, the risks on the “very narrow path” are “upside to inflation”.

“There are people who think we should raise interest rates quite a lot more, but we don’t agree with that,” Bailey said. Inflation is “self-correcting” to some extent, he added, because the shock to real incomes is likely to cut demand. In April, the governor warned there was a risk of over-tightening.

Forward market interest rates imply the policy rate will reach 2.5% in mid-2023. 

By then, inflation is expected to fall back to 6.6%, which is still over three percentage points higher than projected in February. Inflation is expected to be just above the 2% target in Q2 2024, before dropping to 1.3% in 2025. 

It remains unclear whether the MPC will raise rates as high as 2.5%. Most committee members “judged that some degree of further tightening in monetary policy might still be appropriate in the coming months”, according to the meeting minutes. However, others argued this guidance was too strong.

Part of the reason the MPC expects inflation to peak in the autumn this year is because energy and gas price caps are expected to jump in October, but prices should stabilise. 

On why the MPC expects energy prices to stabilise, Bailey said the effect of external shocks is expected to fall away. But, “we need to be focused on the resilience of the energy supply”, he added. The bank is “working closely with the UK government to support its response” to the Russia-Ukraine crisis. 

In April, oil prices were 65% above their level a year ago, and UK wholesale gas prices were almost three times higher. Electricity prices have risen 125%. The BoE expects, on top of a 54% increase in retail gas and energy prices in April, households face a further 40% increase in October.

Despite wages increasing 5.4% in the first three months to February, relative to a year ago, total real household disposable income is expected to fall 1.75% in 2022. That would be its biggest annual drop since 2011, and the second worst since records began in the 1960s. 

It is the poorest members of society with the least bargaining power who will “suffer most”, said Bailey. “It is a great concern.” 

In August, staff will present a plan for selling assets, which the BoE had previously stated it would consider once the interest rate reached 1%. Gilts bought through the Asset Purchase Facility stand at just under £735 billion ($900 billion), down from a post-pandemic peak of £760 billion. The BoE has not been reinvesting bonds that mature.