Bank of England Expected to Raise Bank Rate to 4% as Energy Costs Bite

The Bank of England is expected to raise Bank Rate from 3.75% to 4.0% on Thursday, its first increase since August 2023. The move would come as policymakers respond to inflationary pressure from soaring energy costs, while pushing back against market bets for more increases next year.

Inflation Pressure Builds

Economists polled by Reuters expect the increase. In August 2023, when the BoE last raised rates, inflation was still more than three times the central bank's 2% target. The BoE was criticised for underestimating the persistence of inflation during the previous energy price shock and is keen to avoid repeating that mistake.

Global energy prices remain elevated, with little indication of a lasting end to the war in Iran. Unlike the previous episode, when the BoE was among the first major central banks to raise interest rates, the US Federal Reserve and European Central Bank have already acted ahead of it.

Governor Andrew Bailey has warned that the central bank cannot wait for conclusive evidence of second-round inflationary effects, where rising prices feed into wage demands and businesses' pricing decisions, or risk acting too late. Policymakers remain divided over how much evidence is sufficient and whether the prolonged Iran war will make further inflationary effects inevitable. The Monetary Policy Committee voted 6-3 to hold rates in September. Bailey said last month that businesses he had spoken to appeared to be absorbing higher costs more effectively than they had in 2022.

In September, the BoE warned that inflation could rise above 4% early next year. It said the increase in energy prices since its July forecasts bore similarities to its adverse scenario, in which inflation risks becoming entrenched. Inflation has since exceeded the central bank's expectations. Consumer prices rose by 3.5% in the year to September, compared with the BoE's July forecast of 3.0%.

Divided MPC and Market Bets

Rabobank senior macro strategist Stefan Koopman said the central bank was increasingly being forced to act. He noted that even policymakers inclined to maintain interest rates would eventually have to respond to at least some of the tightening already anticipated by financial markets.

A Reuters poll suggests the November rate increase could pass by a 7-2 vote, with external members Alan Taylor and Swati Dhingra expected to favour keeping rates unchanged. Both have highlighted spare capacity in the economy as a reason to delay further tightening, although recent economic growth figures have been stronger than expected.

More hawkish policymakers, including Chief Economist Huw Pill and external members Catherine Mann and Megan Greene, have criticised the BoE's handling of the current inflation episode. However, even these policymakers may be reluctant to endorse market expectations of another three to four quarter-point increases in 2027. Such increases would take Bank Rate to between 4.75% and 5.0%.

Oxford Economics UK economist Alexander Harvey said the committee was unlikely to provide a clear indication of how many further increases it was considering. He suggested that the meeting minutes or Bailey's comments could indicate that interest rates were unlikely to reach the levels currently anticipated by financial markets. Harvey said individual MPC members' statements would provide important indications of the outlook, particularly those of internal committee members whose positions have remained closely balanced.

Unlike financial markets, economists surveyed by Reuters last month were divided over whether further rate increases would follow November's expected move. Mann has argued that aggressive market expectations for rate hikes partly reflect a risk premium created by the BoE's own wait-and-see approach following the outbreak of war in the Middle East, rather than a clear commitment to controlling inflation.

Budget and Decision Timing

Alongside its updated economic forecasts, investors will also examine the BoE's initial assessment of Finance Minister John Healey's budget, which was delivered last week. Healey announced modest support for households and motorists facing higher energy costs, partly funded through a tax on banks. Economists believe the measures will only marginally reduce the anticipated increase in inflation.

The BoE is scheduled to announce its interest rate decision at 1200 GMT on Thursday, followed by a press conference with Bailey and some of his deputies at 1230 GMT.