Bank of England raises rates and Bailey promises to "stay the course"

[May 11, 2023]  By David Milliken and Andy Bruce

LONDON (Reuters) - The Bank of England raised its key interest rate by a quarter of a percentage point to 4.5% on Thursday and Governor Andrew Bailey said the British central bank would "stay the course" as it seeks to curb the fastest inflation of any major economy.

The central bank is no longer predicting a recession after it revised up growth forecasts from the gloomy projections it released in February, the biggest such improvement since it first published forecasts in 1997.

But it also now expects inflation - which remained above 10% in March - to be slower to fall than it had hoped, mostly due to unexpectedly big and persistent rises in food prices. It also saw stronger wage growth than it previously thought.

"We have to stay the course to make sure inflation falls all the way back to the 2% target," Bailey said in a statement at the start of a press conference.

A Reuters poll last week showed most economists expected a quarter-point rise in May - taking borrowing costs to their highest since 2008 with its 12th consecutive rate rise - and for the BoE to keep rates on hold after that.

But investors have been betting on further increases in Bank Rate and shortly after Thursday's decision, interest rate futures were pricing in a 5% peak for rates this autumn.

"If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required," the BoE said, retaining the same guidance on future actions that it had in February and March.

The pound rose almost half a cent against the U.S. dollar, topping $1.26, while British government bond yields jumped in response to the BoE's move.

"Inflation data will be watched extremely closely over the next few months and may be a source of market volatility especially around currency, with sterling now pricing in more aggressive action from the BoE from here compared to other central banks," abrdn senior economist Luke Bartholomew said.

Policymakers voted 7-2 for May's increase, in line with economists' expectations in the Reuters poll as Monetary Policy Committee members Silvana Tenreyro and Swati Dhingra again expressed their opposition to further tightening.

The BoE was the first major central bank to start raising borrowing costs in December 2021, but it has been accused by critics of not moving aggressively enough as inflation headed towards a four-decade high of 11.1% struck in October.

Last week, the U.S. Federal Reserve and the European Central Bank both raised their benchmark borrowing rates by 25 basis points. While Fed Chair Jerome Powell hinted at a pause, ECB President Christine Lagarde said it was too soon to stop.

Britain's high inflation problem stems largely from its heavy dependence on imported natural gas for power generation, leaving it particularly exposed to the surge in energy prices after Russia's invasion of Ukraine last year.

The Bank of England's Governor Andrew Bailey, Head of Media and Stakeholder Engagement Katie Martin and Deputy Governor, Markets and Banking, Dave Ramsden attend a press conference at the Bank of England, London, Britain, May 11, 2023. REUTERS/Henry Nicholls/Pool

Energy prices have now fallen sharply and the central bank expects inflation to drop to 5.1% by the end of this year from 10.1% in March. But this is less of a decline than the drop to 3.9% it forecast in February and the BoE predicts inflation will not return to its 2% target until early 2025.

Higher forecasts for food prices added about 1 percentage point to future inflation compared with February, the BoE said.

Most BoE policymakers saw "significant" upward risks to these inflation forecasts and inflation was not forecast to significantly undershoot its target at any point in the next few years, even if Bank Rate rises by another quarter point or more.

PAY GROWTH PRESSURES

The BoE is worried that recent strong headline pay growth could turn into a long-lasting problem for the economy, and on Thursday it forecast much stronger wage growth and lower unemployment than three months ago.

"Pay rates could plateau at rates above those consistent with the 2% inflation target sustainably in the medium term," the central bank said.

BoE Chief Economist Huw Pill said last month that British businesses and individuals had to accept that their earnings had fallen in inflation-adjusted terms, triggering criticism from trade unions and some former BoE rate-setters.

The BoE forecast the economy would grow 0.25% this year - compared with its February prediction of a 0.5% contraction.

Cheaper energy, fiscal stimulus and improved business and consumer confidence mean the BoE now no longer predicts a recession this year, and expects the economy to be 2.25% larger in three years' time than it did before.

The government's budget announced in March was expected to boost economic output by around 0.5% over the coming years.

The BoE estimated that around a third of past interest rate hikes had fed through to households and businesses, a slower pass-through than in previous tightening cycles because of a higher share of homeowners with fixed rate mortgages.

(Additional reporting by Suban Abdulla; Editing by Catherine Evans)

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