How will the Bank of England react to the UK's inflation-wage dilemma?

UK inflation hit a fresh 30-year high of 5.5% in the year to January, while average basic pay rose by just 3.7% per year in the quarter to December, lagging behind rising prices.

The consumer prices index reading from the Office for National Statistics on Wednesday, was the highest since March 1992, when it stood at 7.1%, climbing further above the Bank of England’s (BoE) 2% target.

Meanwhile on Tuesday, incomes in Britain saw their biggest squeeze since 2014 in the three months to December as UK wage growth slowed.

After adjusting for recent rises in consumer prices, real total pay fell in the year to October-December 2021, despite a strong recovery in bonuses. Average wages excluding bonuses fell 1.2% – the biggest decline in almost eight years.

The central bank warned earlier this month that consumer price inflation could peak at about 7.25% by April when a 54% surge in energy bills is due to take effect, and the chancellor’s tax rises come into place. But the Bank has so-far underestimated the extent of inflation in previous forecasts.

UK inflation is still being dominated by energy prices, and the prices of a select number of goods, which were heavily affected by the pandemic.

Read more: UK consumer prices hit new 30-year high as inflation rises to 5.5%

Jack Leslie, senior economist at the Resolution Foundation, said: “Today’s increase is consistent with the Bank’s view that inflation will surpass 7% this Spring, which could drive the deepest squeeze on living standards in six decades.”

With inflation expected to rise even further, and businesses and consumers already feeling the squeeze, Threadneedle Street is expected to raise interest rates in March, as well as several times this year.

It will make its next monetary policy announcement on 17 March.

Current market pricing suggests interest rates will increase to 2% this year, the highest since before the global financial crisis. Markets have priced in a half-point increase at one of the next two meetings of the Monetary Policy Committee (MPC).

Analysts at Capital Economics believe that rates will rise from 0.50% now to 1.25% this year and to 2.00% next year, with their inflation forecast rising to a peak of 7.9% in April, up from its previous 7.6% guidance.

Watch: Will interest rates stay low forever?

Meanwhile, ING developed markets economist James Smith, has predicted there will be two, and possibly three, rate hikes in 2022. He also suggested that inflation will begin to dip later this year.

HSBC said the BoE would hike interest rates less than the market fears, “as it knows that the factors behind inflation are also the drivers behind lower real income, which threaten to limit economic growth.”

It expects the Bank rate to rise to 1.25%, lower than the markets’ expectation.

“The pace of price rises has put the Bank of England on a much more hawkish footing and a third month in a row of interest rates rises now looks likely in March,” Ed Monk, associate director at Fidelity International, said.

“That will, of course, squeeze borrowers even more and will add headwinds for the UK economy which has only recently managed to regain the ground lost to the pandemic.”

Read more: UK facing worst cost of living crisis in 60 years

In December, the BoE became the first major central bank to lift borrowing costs from record lows of 0.1% to 0.25%.

In February it then doubled the rate from 0.25% to 0.5%, the second increase since the start of the pandemic, and the first back-to-back hike since 2004.

At the time, four dissenting MPC members voted for a 50 basis point rise to 0.75%, arguing that monetary policy should tighten faster, to “reduce the risk that recent trends in pay growth and inflation expectations became more firmly embedded”, to help bring inflation down to target.

Read more: What higher inflation means for savers and investors

However, Dan Boardman-Weston, CIO at BRI Wealth Management, warned that the Bank should remain cautious, or risk hurting the economic recovery.

“Given the strength of the labour market and the overall economy, it seems inevitable that the Bank of England will continue down the path of further rate rises. It is important that the Bank is cautious with raising interest rates as a lot of this inflation still seems transitory in nature,” he said.

“Raising rates at a time of high household bills and rising taxes could stifle the nascent economic recovery by putting the consumer under too much pressure.”

This was echoed by Ben Laidler, global markets strategist at eToro, who said market expectations of six interest rate hikes this year "look too aggressive".

Watch: How does inflation affect interest rates