Bank of England sounds inflation alarm as it holds interest rates

The Bank of England predicted British inflation will top 4% early next year as it held interest rates unchanged on Thursday, and Governor Andrew Bailey warned explicitly that prolonged conflict in the Middle East may require tighter policy.

Alongside an unexpected decision to pause all the BoE's active sales of gilts for the next six months, the Monetary Policy Committee again voted 6-3 to keep interest rates at 3.75%. Three members voted for a rise to 4%, in line with economists' median forecast in a Reuters poll.

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But the minutes from this week's meeting marked a clear shift in tone that positions the BoE to follow the European Central Bank and U.S. Federal Reserve by raising interest rates.

The Bank of Japan is expected to raise borrowing costs on Friday.

"So far, higher global energy costs have had a limited effect on price- and wage-setting in the UK. But the longer this volatility persists, the bigger the impact it will have on inflation, and the more likely it is we will need to raise Bank Rate to ensure that inflation falls back to our 2% target," Bailey said.

The pound fell by around half a cent against the dollar and British government bond yields dropped after the announcement.

"Interest rates are at a critical cliff-edge moment," Suren Thiru, chief economist at the Institute of Chartered Accountants in England and Wales, said. "While policy could still remain on hold this year, persistent US-Iran hostilities mean the risk of a rate hike has shifted from a possibility to a probability."

INFLATION RISKS ARE STRENGTHENING

The BoE said inflation risks had tilted further to the upside since publishing its last set of economic forecasts in July, adding that the move in energy prices since then bore some similarities to its "adverse" scenario that risked entrenching inflation.

While the BoE noted that signs of persistent pressure were not yet emanating from the labour market and businesses' pricing, the risk was growing.

Felix Feather, an economist at fund management firm Aberdeen, said the Bank could well be hiking at its next meeting in November.

"The November meeting will see the Bank produce a full set of forecasts and hold a press conference, which would give it a better opportunity to explain a change of policy. So it is a natural starting point for a hiking cycle," Feather said.

But most households and businesses will be focused on the shifting outlook for interest rates.

The warning of rate hikes comes at a difficult time for Prime Minister Andy Burnham and his finance minister John Healey, who are trying to strike a positive tone about Britain's economic outlook ahead of the budget on October 28.

While the BoE bumped up its estimate of quarterly economic growth for the third quarter to 0.4% from its previous 0.1% estimate, it said inflation - at 3.1% in August - could "now reach slightly over 4% in early 2027". Previously, the BoE had forecast a peak of 3.2% in late 2026.

Inflation has surpassed the 2% target for all but three months out of the last five years and the BoE strengthened its language surrounding the outlook for price pressures.

"Given the lags with which second-round effects appeared, it was not appropriate to wait too long for evidence of such effects before responding with policy," the BoE said.

RATE HIKE TALK INCREASES AMONG MPC MEMBERS

Chief Economist Huw Pill and external MPC members Megan Greene and Catherine Mann again voted to raise interest rates by a quarter-point.

But this time Governor Bailey and his deputies Sarah Breeden, Clare Lombardelli and Dave Ramsden all raised the prospect of increasing Bank Rate in future in the policy minutes.

The BoE also announced a new long-term plan to unwind its stock of British government bonds accumulated in past attempts to stimulate the economy, which will see active sales of gilts paused for the next six months while the details are nailed down.

The MPC said it aimed to cut its holdings of gilts for monetary policy purposes to zero by 2034, while retaining very long-dated gilts only to back the issuance of bank notes.

It said it would sell its gilts that are due to mature between 2035 and 2049 back to the government, with full plans due before April next year. Short-dated gilts due before 2035 will be held until maturity.