Bank issues recession warning after biggest interest rate rise since 1989

As interest rates rise at their fastest rate for over 30 years, Alice Guy examines what it means for the economy and how high interest rates could go.

Who remembers 1989? It was an amazing year of political change as the Berlin Wall came down and political revolution swept across Europe, country after country throwing off communist rule. A year that started with new power-sharing arrangements in Poland and Hungary soon saw the winds of change blow through East Germany, Czechoslovakia and Romania.

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Closer to home, the Bangles and Kylie & Jason were in the charts, and teenagers across the UK pulled on their neon shell-suits and rushed out to buy a cassette tape of new boy-band sensation, New Kids on the Block.

Meanwhile, interest rates were sky-high compared to today, and they were still on their way up. In October 1989, the Bank of England hiked interest rates from 13.75% to 14.88%, a rise of 1.13%. The rise was partly an attempt to control galloping house prices, which rose by 79% from 1982 to 1989.

Latest Bank of England decision

Today’s Bank of England (BoE) decision harks back to 1989 as a rise of 0.75% is the highest single rate hike since those halcyon days. But the current interest rate and economic environment is a far cry from the late 1980s.

The 0.75% rise is the latest in a long series of increases as the Bank battles to control inflation. The Monetary Policy Committee (MPC) voted by a majority of 7-2 in favour of the rise, one member preferring to increase the rate 0.5% and another by only 0.25%. Today’s decision is in line with expectations and mirrors yesterday's  decision by the Federal Reserve to raise US interest rates by 0.75%.

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Victoria Scholar, head of investment at interactive investor, pointed out that the rise lifts rates “to the highest level since 2008 at the start of the global financial crisis”. The size of the increase signals, “how concerned Bank of England policymakers are about inflation versus a recession as [they look] to curtail further price rises without inadvertently causing unnecessary economic pain”.  

The market reaction has been muted as the rise was broadly expected. And the bumper hike was actually lower than many feared a few weeks ago, when the disastrous mini-budget triggered economic and political chaos. Back then, the markets were pricing in a possible 2% rise, so today’s announcement was a relative relief.

Jim Reid from Deutsche Bank said that “straight after the last meeting, overnight index swaps were pricing in a 75bps hike, but at the height of the mini-budget turmoil they went as far as pricing in more than 200bps worth by today, including a decent chance of an inter-meeting hike. However, as the situation has calmed down, pricing has returned to its original starting point of a 75bps hike again.”

Future economy

In making their decision, the MPC warned that we face a “challenging outlook for the UK economy. It [is] expected to be in recession for a prolonged period and CPI inflation [will] remain elevated at over 10% in the near term.” They also warned that unemployment is likely to double by 2025.

As far as interest rates are concerned, the market is pricing in another 0.5% increase in December, with a possible slowing of rises next year. The market expects rates to peak at around 4.75% sometime next year, but this is by no means certain as inflation and rates will largely depend on energy prices this winter.

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The MPC commented that they expect CPI inflation “to fall back from early next year as previous increases in energy prices drop out of the annual comparison. Domestic inflationary pressures [will] remain strong in coming quarters and then subside. CPI inflation is projected to fall sharply to some way below the 2% target in two years’ time, and further below the target in three years’ time.”

Analysts from the EY ITEM Club are more positive and think that inflation will peak at below 11% in October. They explain that “the government’s intervention on energy bills [headed] off what could have been peak inflation of around 15%. Average annual inflation is still expected to outpace annual average wage increases until 2024, with household real incomes likely to decline over the next 12 months to the greatest extent since the 1970s.” They predict that interest rates will peak at 4% next year.

Mortgage rates

For mortgage holders nearing the end of a fixed deal, it’s a worrying time. Myron Jobson, senior personal finance analyst at interactive investor, commented that “a 0.75% increase in the Bank of England base rate spells bad news for the estimated 2.2 million people on a variable rate mortgage deal. They face paying hundreds of pounds extra a year in repayments – depending on the size of their loan.”

With interest rates possibly increasing and then falling back next year, knowing whether and when to fix is a tricky decision.

Rachel Springall from Moneyfacts says that, “it is unknown whether borrowers would be better off coming out of their fixed mortgage deal early to refinance right now or wait and fall on to their revert rate, because everyone’s circumstances are different. However, sitting on a variable rate does not guarantee peace of mind in the months to come. Depending on how long someone has left on their fixed deal, they may be prepared to accept an early repayment charge to potentially save on their monthly repayments overall with a new deal amid rising interest rates.”

There may be a glimmer of light for mortgage holders as there are signs of some banks reducing fixed-rate deals. Fixed-rate mortgage rates are affected by long-term interest rate trends as bank want to make sure they have enough money to cover future rate rises. Five-year fixes are slightly cheaper than two-year fixed deals, which is a sign that banks expect interest rates to fall in the medium term.