Inflation warning after Bank of England rate hike and Ofgem decision

Policymakers have raised inflation expectations following confirmation of a big increase in the energy price cap. It’s bad news for consumers, but higher interest rates have cheered up bank stocks.

Rising interest rates today added to the cost of living crisis facing households as the Bank of England warned soaring energy bills will mean the highest inflation rate since the 1990s.

With Ofgem's energy price cap set to jump by a bigger-than-expected 54% in April, the Bank thinks that inflation will now peak at around 7.25%. That's a full two percentage points higher than its forecast just three months ago and way above the official 2% target.

The Bank's monetary policy committee today raised interest rates as expected by a quarter of a point to 0.5%, but the extent of their inflation anxieties was shown in the fact that four members voted for an unprecedented half point rise.

Policymakers also began the process of reducing the Bank's pandemic-era balance sheet as part of moves that provided some reassurance to markets about the Bank's determination to tackle the inflation threat.

Sterling rose to its highest level against the euro in two years as the hawkish tone from the Bank prompted the City to forecast at least three more rate rises this year.

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Further hikes are expected in March and May, but governor Andrew Bailey said it would be wrong to "assume that rates are now on an inevitable long march upwards".

It's likely that the Bank will pause on rate rises in the summer as it attempts to strike a balancing act between tackling price pressures and keeping the economy growing.

Due to the expected hit to households' real incomes from higher inflation, the Bank today revised down its GDP growth forecast for 2022 from 3.75% to 3.25%.

Its projections also show that inflation should ease to 1.6% in three years' time if rates rise to 1.5% as markets had previously expected by the middle of 2023. A fall in energy prices later this year would leave this inflation projection even lower at 1.25%.

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Paul Dales of Capital Economics said this suggests that the Bank doesn't believe rates need to rise to 1.5%.

He added: “The signs that it is ready to take more action to get on top of rising cost, price and wage expectations leaves us comfortable with our forecast that it will raise interest rates three more times this year to 1.25%.”

In the short term, however, the squeeze on household finances is about to get considerably worse as higher shop prices are compounded by rising borrowing costs and then April's energy price hike and increased national insurance contributions.

Shortly after the Ofgem price announcement, chancellor Rishi Sunak said he would provide loans of £5.5 billion and grants of £3.5 billion to help households cope with the crisis.

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The impact of today's developments put downward pressure on several retail-focused stocks, with Marks & Spencer (LSE:MKS) off almost 5% in the FTSE 250 index. Watches of Switzerland (LSE:WOSG) and Frasers Group (LSE:FRAS) were also 3% lower amid fears about the impact on consumer spending.

Centrica (LSE:CNA) shares benefited from the bigger-than-expected price cap announcement, with shares up another 1p to 77.66p and further from August's 46p low. The potential return of energy market competition also lifted Moneysupermarket (LSE:MONY) shares by 1.6p to 203.2p.

The domestic-focused FTSE 250 index fell 1% or 219.3 points to 22,030.07, while the FTSE 100 index was more resilient at 45 points lower at 7,538.20. Lloyds Banking Group (LSE:LLOY) and Barclays (LSE:BARC) rose by more than 1% as the hawkish tone from the Bank of England boosted expectations for further support for margins through higher interest rates.