The Bank of England has warned that inflation is set to rise to nearly 5% next year. Policymakers voted unanimously to raise interest rates and hinted that further increases may follow. Traders responded by ramping up bets on another rate hike next month.
The Bank of England's Monetary Policy Committee voted 8-1 to raise rates by 25 basis points to 4%, with external member Catherine Mann advocating for a 50 basis point increase to 4.25%. In a written statement explaining the decision, Bank of England Governor Bailey said, "I think there are grounds for further rate increases, after which policy should take a stance more dependent on circumstances at the time." Bailey added in his prepared remarks, "Today's rate increase should not be seen as the start of an inevitable long sequence of consecutive hikes. But unless the Middle East conflict is resolved, this also seems unlikely to be the last increase."
Traders increased their bets on further Bank of England rate hikes, with the market currently pricing in roughly a 50% probability of a 25 basis point increase in December, and almost fully pricing in three more 25 basis point hikes by the end of next year. The yield on two-year UK government bonds rose 3 basis points to 4.77%, while the pound held steady against the dollar at $1.3472.
Rising energy and fuel costs have already severely squeezed the living standards of UK households. Regulated household energy bills are expected to rise 25% when the price cap is readjusted in January next year, with a further increase in April. The Bank of England expects consumer price inflation to peak at 4.9% in the second quarter of next year, the highest since September 2023.
S&P European economist Marion Amiot said the rate hike was an "obvious decision" following strong economic growth data and signs of improvement in the labor market. She said, "If the economy continues to deliver upside surprises, the Bank of England may have to raise rates again in the first quarter of next year."
Under the adverse scenario set by the Bank of England, if the Iran conflict repeatedly escalates, CPI inflation would rise to 6.2% in the third quarter of 2027. Even under a milder scenario, where no second-round effects emerge, inflation would still rise to 4.8% early next year, mainly due to the planned increase in the household energy price cap in January. By comparison, in the previous round of forecasts published in July, the Bank of England projected a peak inflation rate of only 3.2%.
The Monetary Policy Committee emphasized that it acted early to guard against rising costs further affecting wage and price setting. So far there is little evidence of second-round effects, but the committee is concerned that such effects could emerge once companies' "hedging arrangements and long-term fixed-price contracts" expire. External MPC member Alan Taylor, one of the most dovish members, wrote, "This is an insurance rate hike driven by risk management considerations, for now just this one." Bank of England Deputy Governor for Markets Dave Ramsden said, "Less favorable initial conditions increase the risk of second-round effects."
Since energy prices have deviated far from the Bank of England's previous expectations, the Monetary Policy Committee adjusted its policy guidance, stating it "will continue to assess the evidence at each meeting, with particular attention to the extent to which high energy prices may pass through to other prices and the broader economy."
The Bank of England raised its GDP growth forecast for this year from 1.1% to 1.6%, and its 2027 growth forecast from 1.1% to 1.3%. However, based on the assumption that the impact of the energy shock will persist, the Bank of England lowered its 2028 growth forecast from 1.7% to 1.2%. Under a "weaker demand" scenario, inflation would fall sharply to 1.2%, implying that rate cuts may be needed at that point.
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