The Bank of England unveiled a dismal vision for the British economy on Thursday, predicting a long recession starting later this year as the impact of high inflation bites. But the central bank strengthened its effort to tackle soaring prices as it raised interest rates by half a percentage point, the largest jump since 1995.
The bank increased its benchmark rate to 1.75 percent, the highest since 2008, as it forecasts that the annual rate of inflation will climb above 13 percent when household energy bills jump higher in October. That would be the highest level of inflation in 42 years, and six times the bank’s 2 percent target.
Much of the surge in prices is still coming from the global energy market, the bank said. In the past three months, wholesale natural gas prices for this winter have nearly doubled, which the bank predicted would push the cap on household energy bills up to 3,500 pounds (about $4,245) in the fall, three times the amount a year ago.
The outlook for millions of British households is grim. Incomes, adjusted for inflation and taxes, are predicted to fall sharply this year and next, in the worst decline in records dating to the 1960s.
Britain, the world’s fifth-largest economy, will enter a recession in the last quarter of this year that will last through 2023, the bank forecast, the same length of the recession after the financial crisis in 2008.
“The latest rise in gas prices has led to another significant deterioration in the outlook for activity” in Britain and the rest of Europe, policymakers said, according to the minutes of this week’s meeting. Britain “is now projected to enter recession.”
The rate change announced on Thursday was the sixth increase since December as the bank tries to tackle inflation, which is running at its fastest pace in four decades. It has been under some pressure to increase rates by more than its usual quarter-point move as inflationary pressures persist and other major central banks take more aggressive action to halt price increases.
The Bank of England was the first major central bank to start raising rates in response to global inflation as it reined in monetary policies that supported the economy during the pandemic. The European Central Bank raised interest rates last month for the first time in more than a decade. And in the United States, the Federal Reserve raised rates last week by three-quarters of a percentage point for the second straight month.
There is little the banks can do to slow energy prices or ease supply chain disruptions, but their goal is to make sure rapid price rises do not last too long by making it more expensive for consumers and businesses to borrow money. So far, unemployment has remained generally low in the United States, the European Union and Britain, but the risk is that in trying to bring down inflation, policymakers will cause deep downturns and layoffs. The International Monetary Fund warned last month that a global recession could be at hand.
Global inflation has been exacerbated by the war in Ukraine and Western sanctions on Russia, which have further interrupted supply chains and driven up the cost of energy.
“There is an economic cost to the war,” Andrew Bailey, the governor of the bank, said on Thursday. “But it will not deflect us from setting monetary policy to bring inflation back to the 2 percent target.”
In Britain, consumer prices rose 9.4 percent in June from a year earlier, faster than inflation in the United States and the eurozone.
The National Institute of Economic and Social Research, a London think tank, said on Wednesday that the economy was entering a recession this quarter and would lose 1 percent of gross domestic product over three quarters.
“We’re really in stagflation here,” Stephen Millard, the deputy director of the research institute, said before the bank’s decision.
As high inflation meets a recession, household incomes are being squeezed because pay growth isn’t keeping up with rising prices. The research institute has called for more government support to low-income households as food prices continue to rise and household energy bills jump, perhaps by as much as 75 percent in the fall.
The Bank of England’s own forecasts are even gloomier. Next year, the economy will contract 1.5 percent, it predicted, assuming no change in fiscal policy. It shows the scale of the economic challenge facing the two Conservative lawmakers battling for the party leadership and role of prime minister. Much of the debate so far has centered on taxes, with Liz Truss, the front-runner, vowing to quickly cut them for workers and businesses amid a cost-of-living crisis.
Ms. Truss has also said she would re-evaluate the bank’s mandate from the government to ensure price stability, to make sure “it matches some of the most effective central banks in the world at controlling inflation.” The central bank has been independent of the Treasury since 1997, but the government still sets the inflation target. Mrs. Truss added that it had been a long time since the mandate was scrutinized.
Mr. Bailey avoided getting drawn into speculation about a new mandate in a news conference on Thursday. “I’m not going to comment on anything that has been said by the candidates to be leader of the Conservative Party,” he said.
Even as the economic outlook worsens, the central bank has emphasized its primary goal in bringing down inflation. Eight of the nine members of the rate-setting committee voted for the outsize move amid signs that inflationary pressures were becoming more persistent and emerging in more parts of the economy.
“The mix of high near-term inflation and weak activity leading up to a recession is a challenging backdrop for monetary policy,” but the focus must remain on inflation and inflation expectations, Mr. Bailey said.
The inflation picture has deteriorated rapidly. In December, when the bank first raised rates, it predicted inflation would peak at 6 percent in April. Now that peak is six months later and more than twice as high. Higher energy prices are a primary reason for the rapid inflation, the bank said, but supply chain disruptions and domestic inflation pressures are also rising.
Inflation for consumer services, which are much less affected by the global price of goods, was up 5.2 percent in June from a year earlier, the highest since early 1993. The tight labor market is also pushing up inflation. Unemployment is low and job vacancies are high, so underlying wage growth is rising as employers compete to hire and retain staff. Meanwhile, companies are passing along a larger share of their cost increases to their customers.
Even though some contributors to inflation are showing signs of easing, such as global commodity prices, policymakers took only limited comfort from these signals. There is a risk that a longer period of inflation generated by external factors, such as global energy prices and pandemic-related supply chain disruptions, will lead to “more enduring” price and wage pressures at home, the minutes said. This was one of the reasons for the larger-than-usual interest rate increase.
There are “exceptionally large” risks around the bank’s economic and inflation forecasts, Mr. Bailey said. But inflation should fall back towards the bank’s target in two years, based on financial market expectations about the future path of interest rates. As the bank was producing its forecasts, markets expected rates to rise to 3 percent in the first half of next year and then decline.
Policymakers are likely to increase rates more cautiously than markets expect because the dominant force driving prices higher — the cost of natural gas — is outside the control of monetary policy, Martin Beck, an economic adviser at EY, said in a note to clients. Those higher energy prices will eventually reduce demand and, therefore, cause prices to fall, he added.
While the bank is using higher interest rates as its main tool to restrain inflation, in the background it is also reversing one of its major policies that helped support the economy during the pandemic: bond buying. Until December, the bank increased its holdings of British government bonds to £875 billion but has since stopped reinvesting the proceeds from maturing bonds, allowing its balance sheet to shrink.
Next month, it expects to take a step it has never done before and start selling bonds back to the market. It expects to sell about £10 billion in bonds each quarter for the first year, if the market conditions are appropriate and policymakers vote to begin the process.
With so much uncertainty about the economy and prices, the bank offered fewer hints about the future path of interest rates, emphasizing, as other central banks have done recently, that it will base its decisions on the latest data.
“Policy is not on a preset path,” the minutes said.