Bank of England set to raise rates again as inflation heads for 10%

The Bank of England looks set to override its worries about a sharp slowdown in the British economy and raise interest rates again on Thursday as it tries to tackle an inflation rate on course for double digits.

After the U.S. Federal Reserve upped borrowing costs by the most since 1994 with a 75 basis-point rate hike on Wednesday, the big question for investors awaiting the BoE's June policy announcement at 1100 GMT is the size of the increase.

Financial markets are fully pricing in a quarter percentage-point increase in Bank Rate to 1.25%.

But investors have put a nearly 50% probability on a half-point rise by the BoE, something it has not done since 1995.

The BoE has already raised borrowing costs four times since December when it became the first of the world's major central banks to increase rates after the coronavirus pandemic.

Britain, more than many other rich nations, is facing a mix of high inflation and zero growth or a recession.

Its economy is already showing signs of a slowdown and will be the weakest among the world's big, rich countries next year, according to forecasts by the International Monetary Fund and the Organisation for Economic Co-operation and Development.

But inflation, which hit a 40-year high of 9% in April, is set to surpass 10% later this year, more than five times the BoE's 2% target, according to the central bank's latest forecasts.

Those forecasts could yet prove too low after a recent fall in the value of the pound which will add to the cost of imports, chief among them oil and gas.

"Britain is stuck in the worst of both worlds and that's what makes policymaking so difficult," Luke Bartholomew, a senior economist with investment firm abrdn, said.

"It's still got a tricky period ahead with inflation ratcheting higher and growth slowing."

Part of the British inflation problem is the country's mechanism for regulating domestic power prices which means the rise in prices is likely to last longer than elsewhere.

Britain also has a severe shortage of workers to fill vacancies which is pushing up pay sharply for some and could add fuel to the inflation fire.

Then there is the unfinished business of Brexit. Britain and the European Union are again at logger-heads which could lead to bigger trade barriers with the bloc and higher prices.

The BoE is likely to signal again on Thursday that its series of rate hikes has further to run, although last month it suggested investors were going too far by pricing in Bank Rate hitting 2.5% by the middle of next year.

Since then, those rate hike bets have risen again with markets pricing Bank Rate at almost 3% as soon as December.

The climb is partly due to expectations of more cost-of-living help by the government after finance minister Rishi Sunak announced fresh support in May and with Prime Minister Boris Johnson seeking ways to shore up his flagging popularity.

David Zahn, head of European fixed income at Franklin Templeton, said yields on short-term British government bonds probably had only a bit higher to rise.

"I think we are getting very close to the inflection point where the central bank will probably have to stop hiking," he said. "The Bank of England might do one or two more (rate hikes), but I think we will be in recession later this year in the UK."