The Bank of England has increased interest rates by a quarter of a percentage point, to 0.5 per cent and signalled that the first rate rise in a decade will be the start of a gradual increase in borrowing costs.
Voting seven to two in favour of the rate rise, the bank’s Monetary Policy Committee forecast that inflation would remain well above the central bank’s 2 per cent target if interest rates had stayed at 0.25 per cent. The committee indicated that two further quarter of a percentage point rate rises would be needed during the next two years to control prices.
The BoE forecasts that if interest rates rise to 1 per cent by late 2019, inflation will be broadly under control in the medium term. But the MPC stressed “future increases in the bank rate would be expected to be at a gradual pace and to a limited extent”.
That guidance sent the pound sharply lower and sparked demand for UK government debt, pushing gilt yields lower. Sterling fell 1 per cent against the dollar to $1.3113, and weakend by 1.3 per cent against the euro, with £0.8882 required for a unit of the shared currency.
The yield on benchmark 10-year UK government bonds fell by 8.1 basis. The policy-sensitive two-year gilt fell 7.5bp to 0.411 per cent. The blue-chip FTSE 100 stockmaket index was up 0.6 per cent.
The first monetary tightening in a decade came despite forecasts for relatively weak UK economic performance. The MPC now expects the British economy to grow at about 1.7 per cent a year during the next three years, well below the 2.5 per cent average seen since the second world war.
The MPC warned in its statement that Brexit-related uncertainty is taking a toll on demand, saying: “Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly.”
But the MPC said the slow rate of growth is still greater than the UK economy can withstand without generating inflation, citing Brexit-related uncertainties, low productivity growth and limited scope to increase employment rates.
“Brexit-related constraints on investment and labour supply appear to be reinforcing the marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressures,” the MPC added.
For the first time, the BoE said it thought the potential rate of growth for the UK economy is now only 1.5 per cent a year, meaning that any faster expansion creates pressure for higher interest rates.
Before the financial crisis, the BoE, the Treasury and most independent forecasters thought the UK economy could grow at least 2.5 per cent without running into problems.
The MPC now expects October inflation figures to show consumer prices rose 3.2 per cent last month compared with the same time last year. If that happens, BoE governor Mark Carney will have to write a letter to chancellor Philip Hammond explaining why inflation has moved more than 1 percentage point above the central bank’s 2 per cent target.
However, the BoE expects inflation will fall back later this year, as price rises reflecting weaker sterling fall out of the annual comparisons. The central bank predicts inflation will fall to 2.15 per cent by late 2020.
The BoE’s predictions assume that as sterling depreciation becomes less important in measuring inflation, price rises will be increasingly generated by rising wages and domestic costs.
The two dissenting voices on the MPC who voted against the rate rise — deputy governors Dave Ramsden and Jon Cunliffe — argued “there was insufficient evidence so far that domestic costs, in particular wage growth, would pick up in line with the . . . central projection”.
The BoE said the rate rise was likely to have a small effect on household budgets, as many British households have fixed-rate mortgages, and that any effects on disposable income and spending were likely to take some time.