Bank of England raises rates to 2.25%, despite likely recession

The Bank of England raised its key interest rate to 2.25% from 1.75% on Thursday and said it would continue to "respond forcefully, as necessary" to inflation, despite the economy entering recession.

The BoE estimates Britain's economy will shrink 0.1% in the third quarter, partly due to the extra public holiday for Queen Elizabeth's funeral, which combined with a fall in output in the second quarter would meet the definition of a technical recession.

Economists polled by Reuters last week had forecast a repeat of August's half-point increase in rates, but financial markets had bet on a three-quarter-point rise, the biggest since 1989, barring a brief, failed attempt in 1992 to support sterling.

The pound slid by more than half a cent against the U.S. dollar after the decision and dipped below $1.13, after hitting a new 37-year low close to $1.12 earlier in the day. British government bond prices fell sharply.

The BoE move follows the U.S. Federal Reserve's decision on Wednesday to raise its key rate by three quarters of a percentage point, as central banks worldwide grapple with post-COVID labour shortages and the impact of Russia's invasion of Ukraine on energy prices.

"Should the outlook suggest more persistent inflationary pressures, including from stronger demand, the Committee will respond forcefully, as necessary," the BoE said, using a similar form of words to previous months for its policy intentions.

The BoE's Monetary Policy Committee voted 5-4 to raise rates to 2.25%, with Deputy Governor Dave Ramsden and external MPC members Jonathan Haskel and Catherine Mann voting for an increase to 2.5%, while new MPC member Swati Dhingra wanted a smaller rise to 2%.

Financial markets now see a roughly three-quarters chance that the BoE will raise the Bank Rate again to 2.75% at its next meeting in November. Before the decision, a rate of 3% was fully priced in.

"The Bank of England ... continues to look like something of a laggard compare to international peers, which is likely to keep the pound under selling pressure," said Luke Bartholomew, senior economist at investment company abrdn.

The MPC also voted unanimously to reduce the BoE's 838 billion pounds of government bond holdings by 100 billion pounds over the coming year, by allowing bonds to mature and through active sales, which will start next month. This is in line with the goal it stated in August.

The BoE now expects inflation to peak at just under 11% in October, below the 13.3% peak it forecast last month, before Liz Truss won the Conservative Party leadership and became Britain's prime minister with a promise to cap energy tariffs and cut taxes.

Inflation would remain above 10% for a few months after October, before falling, the BoE said.

Consumer price inflation fell to 9.9% in July from a 40-year high of 10.1% in August, its first drop in almost a year.

On Friday, new finance minister Kwasi Kwarteng will give more detail about the government's fiscal plans, which may amount to more than 150 billion pounds of stimulus.

The BoE said it would assess the implications of this for monetary policy at its November meeting.

However, it noted that the energy price cap, while reducing inflation in the short term, would boost pressures further out.