Bank of England warns of UK recession this year as it lifts interest rate

The Bank of England has warned that the UK economy will slide into recession this year as higher energy prices push inflation above 10 per cent, a forecast that pushed sterling to a two-year low.

Despite forecasting a severe fall in household incomes, the bank’s Monetary Policy Committee voted on Thursday to squeeze them further, raising the main interest rate by a quarter-point to 1 per cent, its highest level since February 2009.

Three of the nine MPC members voted for a half-point rate increase.

The bleak economic forecast took its toll on sterling. The pound was down almost 2 per cent against the dollar at $1.2383 in early afternoon trading. And with interest rates now not expected to rise as fast as previously, the government’s cost of borrowing over two years, a price that is highly sensitive to monetary policy expectations, tumbled 0.25 percentage points to 1.37 per cent.

The MPC said it was “unable to prevent” UK households from becoming worse off and its role was to ensure inflation came down to its 2 per cent target sustainably in the medium term.

Andrew Bailey, BoE governor, said there would be a “very sharp slowdown” and he understood that higher energy prices and borrowing costs would hurt. “I recognise the hardship that this will cause,” he said, blaming most of the pain on energy prices rather than higher borrowing costs.

The message from the central bank was less aggressive on future interest rate rises than financial markets had expected.

Seven MPC members signed up to a statement that said: “Some degree of further tightening in monetary policy might still be appropriate in the coming months.” Two members of the committee thought the coming economic difficulties would be sufficient to drive out inflation and this guidance that interest rates needed to rise further “was not appropriate”.

The committee also decided not to start monthly sales of the £875bn of assets that the BoE built up under its quantitative easing programmes since 2009, preferring instead to “work on a strategy for UK government bond sales” that would start at the earliest after August.

Unlike the US Federal Reserve, the BoE was not confident it could engineer a soft landing for the economy. Instead, unusually gloomy BoE forecasts predicted the economy would contract 1 per cent in the fourth quarter of this year after gas and electricity costs rose another 40 per cent in October.

It said these rises in energy bills were likely to push inflation up to 10.2 per cent in the fourth quarter of 2022, the highest in 40 years and slash real household incomes because wages would not keep pace.

Line chart of pound trading against the dollar in 2022 showing sterling extends decline after the UK raised rates again

Another dip in GDP was likely in the third quarter of 2023, the BoE added, when the government’s temporary incentives for business investment ended, leaving the economy 0.8 per cent smaller than in the summer of 2022.

Unemployment, it said, would rise from 3.8 per cent to 5.5 per cent by 2025 and this would help moderate wage claims and bring down inflation.

Thereafter, the MPC now expects the UK economy to recover only weakly from the coming recession, suggesting that the economy could not withstand growth of much more than 0.6 per cent a year without inflation taking off again.

The three dissenting MPC members — Jonathan Haskel, Catherine Mann and Michael Saunders — worried that persistent high inflation would be difficult to eradicate. In the minutes, they called for a half point interest rate rise to prevent “recent trends in pay growth, firms’ pricing strategies and inflation expectations in the economy more widely [becoming] more firmly embedded”.

Karen Ward, a markets strategist at JPMorgan Asset Management, said that overall the BoE had faced a difficult decision and had revealed a clear intent to drive down inflation despite its miserable forecast.

“Today’s unanimous vote to raise interest rates suggests inflation concerns dominated the meeting and indeed three members voted for a larger half point hike,” she said.

“The combination of the pandemic and Brexit has changed the fundamentals of the UK economy — particularly its ability to generate persistent inflation. The bank will have to keep raising rates to bring inflation down, but a gradual approach, as taken today, is understandable,” Ward added.

Additional reporting by Tommy Stubbington