The Bank of England (BoE) has raised interest rates to 1.75% from 1.25% – the highest level since January 2009.
A warning has also been issued by the BoE that the UK is set to plunge into the longest recession since the financial crisis.
The recession is set to begin in autumn, and last for more than a year, as millions of households grapple with the cost of living crisis.
The BoE has also predicted inflation will peak at more than 13% as gas prices soar.
Its decision to swell rates by 0.5 percentage points represents the largest single hike in 27 years.
Its updated forecast also warned Consumer Prices Index (CPI) inflation is expected to peak at 13.3% in October – the highest level since September 1980 – if the regulator Ofgem hikes the price cap on energy bills to around £3,450.
It comes as the energy regulator today announced a change to its price cap updates – confirming they will be reviewed every three months instead of six.
What the interest rate rise means for your finances
The energy price will push the economy into a five-quarter recession, with gross domestic product (GDP) shrinking each quarter in 2023.
“Growth thereafter is very weak by historical standards,” the BoE said on Thursday.
Real household incomes will drop for two years in a row due to the alarming economic conditions – the first time this has happened since records began in the 1960s.
Bank of England predicts long recession in UK as inflation peaks above 13%
In 2022 they will drop by 1.5%, followed by a 2.25% fall during 2023. However, the recession will at least be shallower than the one witnessed in 2008. Bank officials said that the depth of the drop is more comparable to the recession in the early 1990s, while projections expect the unemployment rate to start rising again next year.
It won’t be until 2023 that the bank predicts to have inflation under control, with the measure expected to drop below 2% towards the end of the year.
“The United Kingdom is now projected to enter recession from the fourth quarter of this year,” the Bank’s Monetary Policy Committee (MPC) said. “Real household post-tax income is projected to fall sharply in 2022 and 2023, while consumption growth turns negative.”
Director of Henry Dannell mortgage brokers, Geoff Garrett, warned the inflation hike would have a significant effect for anyone hoping to buy a home.
“We’ve recently seen both the European Central Bank and the US Federal Reserve implement rate increases of 0.5% and 0.75% respectively and this has forced the Bank of England’s hand to act similarly in an effort to tighten their grip on rising inflation.
“If it hasn’t already, this latest base rate jump will reverberate throughout the mortgage sector almost immediately, the result of which will be a notably higher cost for homebuyers and owners when borrowing to climb the ladder.”
How does the £400 energy bill discount work and how do you claim the money?
Why have interest rates risen?
Interest rates are usually raised when inflation starts to surge out of control as a way of bringing it back down to normal levels.
In July inflation reached 9.4%, which is the highest the measure has been for 40 years.
Inflation is the rate at which the prices of goods and services are rising.
It directly impacts bills such as households’ mortgage payments, and have knock-on effects for renters if landlords pass on the hikes to tenants.
Meanwhile, the Resolution Foundation has predicted that the inflation could rise even higher – potentially reaching 15% in early 2023.
An analyst at the foundation, Jack Leslie, said there was still substantial uncertainty about how prices will evolve over the coming year, as Russia’s Ukraine invasion sends global gas prices soaring.
He said: “Higher and more persistent inflation both mean that the BoE faces a protracted period of challenging policy making. More importantly, low-to-middle income families are likely to face disproportionately higher living cost levels for the foreseeable future.
When the BoE increased interest rates from 1% to 1.25%, in June, it blamed an “additional large increase” in OFGEM’s energy price cap, scheduled for this winter, and signs that prices are rising “across the major components of consumer prices”.
Higher interest rates could mean that borrowing becomes more expensive for consumers, and, for example, affect people taking out a mortgage or buying a car.
Why is inflation rising?
Inflation is being pushed higher because supply chains around the world are being impacted by both the Covid pandemic and Russia’s conflict in Ukraine.
Fuel prices, for example, have been exasperated by the war, which has led to a number of countries imposing sanctions against Russia – one of the largest exporters of crude oil in the world.
There are fears Vladimir Putin’s war will drive up energy bills even further, after Moscow strangled gas flows through the Nord Stream 1 pipeline to the EU – sending wholesale gas prices rocketing further.
Lockdowns and high workforce absences triggered by the pandemic have also led to delays in meeting high levels of demand from consumers.
Following today’s rates hike announcement, BoE governor Andrew Bailey said there is an “economic cost to the war” in Ukraine, but insisted it will not deflect the Bank from “setting monetary policy to bring inflation back to the 2% target.”
Warning UK on brink of ‘stagflation’ as households struggle with cost of living
Could things get worse?
Experts think that inflation will rise further yet by October when the next energy price cap review takes effect.
Consequently, the bank could opt to raise interest rates even further in an attempt to quell further growth.
Chief executive of Citizens Advice Scotland, Derek Mitchel called for “radical action” from the Government.
He said: “Some of the most vulnerable people across the UK this winter will face a choice between freezing and starving.
“Inflation is expected to stay high for much of 2023 and the looming prospect of a recession means this crisis isn’t going anywhere, risking a legacy of debt, poverty and destitution for years and years to come.”
How can you combat rising interest rates?
Insurance company Royal London has suggested several steps to help UK residents cope with the rise in rates.
They include checking to see how much interest your savings are earning and using comparison or mortgage broker websites, to see how your variable mortgage rate compares to the best buys.
It also recommends talking to your lender or a debt advice charity such as StepChange or National Debtline.
What is the political reaction?
Tory leadership hopeful and former chancellor Rishi Sunak said: “One of the most urgent challenges we face as a country is getting inflation under control as quickly as possible.
“The Bank has acted today and it is imperative that any future government grips inflation, not exacerbates it.
“Increasing borrowing will put upward pressure on interest rates, which will mean increased payments on people’s mortgages. It will also make high inflation and high prices last for longer, making everyone poorer.
“As prime minister I would prioritise gripping inflation, growing the economy and then cutting taxes.”
Leadership hopeful Liz Truss said: “We need to take immediate action to deal with the cost-of-living crisis, grow the economy and delivering as much support to people as possible.
“As prime minister, I’d use an emergency budget to kickstart my plan to get our economy growing and offer immediate help to people struggling with their bills.
“Through supply side reforms, dealing with burdensome business regulation and cutting taxes, I will get our economy back on track. My tax cuts are necessary, affordable and not inflationary.
“You cannot tax your way to growth. Business as usual will not do.
“Instead, we need a new approach on the economy, we need to challenge the failing economic orthodoxy and we need to deliver the necessary reform to tackle inflation and achieve sustainable growth.“
However, Labour’s Rachel Reeves, Shadow Chancellor of the Exchequer, accused the Tories of losing control of the economy while they focused on the leadership race, as mortgage and borrowing rates continue to rise.
She said: “As families and pensioners worry about how they’re going to pay their bills, the Tory leadership candidates are touring the country announcing unworkable policies that will do nothing to help people get through this crisis.
“Labour would help households right now by removing the tax breaks that are subsidising oil and gas producers and using that money to help people now, including by cutting VAT on energy bills.”
Ofgem confirms price cap update every three months in ‘challenging winter ahead’
Renters warned landlords who include bills may keep £400 energy discount