Bank of England set to raise UK's interest rates to 1.25%

The Bank of England in London
The Bank of England's Monetary Policy Committee will meet on Thursday to decide on interest rates. Photo: Neil Hall/Reuters (Neil Hall / reuters)

The Bank of England is set to raise UK's interest rates to 1.25% when the Monetary Policy Committee (MPC) meets on Thursday.

The last time rates breached 1% was in 2009. Gordon Brown was the UK's prime minister and the world was still facing tailwinds of the 'Financial Crisis', with central banks pouring trillions via quantitative easing to shore up the global economy.

Bank bailouts were rampant and the housing market hadn't yet recovered from the subprime mortgage scandal. Crypto wasn't a term. Bitcoin's value was zero. The bitcoin (BTC-USD) network had just gone live with the mining of the genesis block, which allowed the first group of transactions to begin a blockchain. Few knew or cared about blockchain or mining, unless it referred to literal mining.

Fast forward 13 years and the world is facing a concoction of crises. A global pandemic on the wane, but still potent, a war that has lifted oil prices to dizzy heights, evoking the ghosts of the 1973 oil crisis, and in turn spawning an energy crisis; and while banks have been made to comply with Basel III standards to ensure adequate liquidity and strengthen regulation, loose monetary policy for years has let slip inflation out of hand.

Prices of goods are rising across the globe, tellingly in the developed economies including the US where the Federal Reserve is in a real dilemma of getting it's balancing act right amid tanking tech stocks that has plunged stock markets into a bear territory.

Read more: UK inflation hits 40-year high as cost of living squeeze intensifies

In the UK, inflation has hit 9%, with some studies pointing out poorest household will face 14% inflation by October. Chancellor Rishi Sunak has been compelled to make another U-turn and announce emergency aid of £15bn to help households with the rising cost of their energy bills.

UK's GDP has fallen and the economy is contracting. The OECD has forecast the UK will be the weakest G7 economy in 2023. Real wages are falling at fastest rate in 20-years.

The MPC when it meets for it's six-weekly session on Thursday thus has little option but to raise the interest rates.

The logic is simple: raising cost of borrowing would deter spending and make saving more attractive. The fall in spending should eventually bring prices down (that part is not simple, though). But broadly that is the thinking to keep inflation at BoE's preferred target of 2%.

Interest rate, as defined by the Bank, is what you pay for borrowing money, and what banks pay you for saving money with them. Its purpose is to help regulate inflation.

Watch: How does inflation affect interest rates?

Analysts and surveys widely predict a 25 basis point raise, which will take the interest rates, or the Bank Rate as it is often referred to, from 1% to 1.25%. UK households are already braced for the rise, as per the latest S&P (^GSPC) Global UK Household Interest Rate Expectations Index. Its survey findings published on Wednesday show that 56% of UK households expect a hike.

Lewis Cooper, economist at S&P Global Market Intelligence, said: “UK households are braced for a fifth interest rate hike, according to the latest survey data, with the net balance of those expecting an imminent increase in the base rate amongst the highest on record.

"It’s clear that UK households expect the central bank to take further action to tackle strong inflation and hawkish expectations appear to be little dampened by ongoing macroeconomic concerns and the cost of living crunch.”

The BoE’s recent survey on the public’s attitudes to inflation also found that almost a third of respondents said it would be better for them if interest rates were to "go up".

Markets are also factoring in an imminent rate rise with investment banks advising their clients to build portfolios around the expectation of multiple rate rises by the Bank of England, European Central Bank and the US Federal Reserve.

Read more: Is the UK heading into a recession?

"Looking ahead, we now expect the BoE to hike [rates] in every meeting this year and one more time in Feb-23. While our previous call had the bank rate peaking at 1.75% – within the range of neutral, which we broadly put at 1.25% to 2% – our updated call has bank rate going to 2.5%," Deutsche Bank (DB) said in a note to its clients.

Financial conglomerate Nomura said the markets are pricing in around a 40% chance of a 50bp rate hike from the Bank of England this week, with a total of over 75bp in hikes now priced in for the June and August decisions combined. Nomura's own analysis however predicts "a 25bp (not 50bp) rate hike this Thursday and then again at the August and November meetings".

Inflation has also hit pound, pushing it down to a two-year low against the dollar. Should BoE waiver on rates decision, this will further damage the pound – another reason why MPC is likely to vote for a hike.

“The Bank of England faces a stern test of its mettle at the next interest rate decision, and any hesitation is likely to result in the pound being punished on the currency markets.

"Sterling has already fallen around 8% against the dollar this year, even though markets are pricing in a fifth consecutive interest rate rise in June, so any signs of dovishness could weaken the currency further," said Laith Khalaf, head of investment analysis at AJ Bell.

"By raising interest rates, the Bank is putting the brakes on an economy that is already slowing of its own accord. That risks the economy stalling, or worse, going into reverse.

"But if the Bank fails to take action and the pound comes under further pressure, that also adds to the cost of living crisis, by pushing up the price of commodities priced in dollars, especially fuel. It feels like there are simply no good options in front of the Bank of England."

Read more: UK real wages fall to 20-year low as job vacancies rise to 1.3 million

Investment platform Interactive Investor simulated its own MPC to gauge the rates sentiment. Its People's Interest Rate Panel voted for the bank rate to be increased by 0.25 percentage points to 1.25%.

“Interest rates must continue on an upwards trajectory to rein in inflation, despite concerns about the impact higher interest rates will have on the cost of borrowing and mortgage rates," said Myron Jobson, senior personal finance analyst at Interactive Investor.

Credit ratings agency Fitch Ratings also expects multiple hikes this year. In its Global Economic Outlook for June 2022 it said it expects the BoE to hike rates to 2% by the fourth quarter of 2022 and 2.5% by first quarter of 2023.

Watch: What is a recession and how do we spot one?