The Bank of England raised interest rates by a larger-than-anticipated half a percentage point on Thursday due to substantial indications that British inflation would decline at a slower pace. The Monetary Policy Committee (MPC) of the BoE voted 7-2 in favour of increasing the main interest rate from 4.5% to 5%, the highest level since 2008 and the largest rate hike since February. This decision followed higher-than-expected inflation and wage growth since the previous MPC meeting in May.

After the announcement, BoE Governor Andrew Bailey stated, "The economy is performing better than expected, but inflation remains too high, and we need to address it. If we don't raise rates now, the situation could worsen later." Economists surveyed by Reuters had predicted a move to 4.75%, although financial markets earlier in the day had indicated a nearly 50% chance of a rise to 5% following the release of inflation data exceeding expectations on Wednesday.

Following the BoE's decision, the British pound briefly surged against the U.S. dollar, while two-year bond yields momentarily dipped below 5%. The inversion of the two-year to 10-year yield curve, often seen as a sign of an impending recession, deepened.

HSBC Asset Management's Global Chief Strategist, Joseph Little, commented that Britain is in a more challenging position compared to other major Western economies due to the cost of living crisis, labor shortages, and rapidly rising wages. Little added, "Inflation pressures in Britain show more persistence and momentum than in other western economies, forcing the Bank into a hawkish stance. Today's statement has increased concerns about a much higher terminal policy rate, potentially as high as 6%."

Leading up to Thursday's announcement, BoE policymakers had not given clear indications that a half-point rate increase was being considered. However, the MPC stated, "Recent data has shown significant positive developments suggesting that inflationary pressures are likely to persist for a longer duration. Second-round effects on domestic prices and wages, resulting from external cost shocks, are expected to take longer to unwind than they did to emerge."

MPC members Silvana Tenreyro and Swati Dhingra opposed the rate hike, as they have done with all increases this year. They argued that the full impact of previous tightening measures had yet to be felt, and forward-looking indicators pointed to substantial decreases in inflation and wage growth in the future.

High inflation in Britain also poses a challenge for Prime Minister Rishi Sunak, who pledged to halve the rate of price growth this year in an effort to regain voter support ahead of the anticipated national election in 2024. A spokesperson for Sunak expressed support for Bailey, and Finance Minister Jeremy Hunt stated that the BoE had his complete backing, emphasizing that "relentlessly tackling inflation" should be the immediate priority.

Bailey has faced criticism from some lawmakers in Sunak's Conservative Party for not acting sooner and more aggressively to address inflation.

In recent days, expectations of BoE rate tightening have surged, leading to a significant increase in the cost of new mortgages. Before Thursday's decision, financial markets anticipated that the BoE's Bank Rate would reach 6% by the end of the year, while economists surveyed by Reuters last week projected a peak of 5%.

Although Britain's economy has managed to avoid an anticipated recession thus far in 2023, it has struggled to fully recover to pre-pandemic levels, unlike most other major advanced economies. BoE forecasts from last month suggested that growth this year would be a minimal 0.25%.

The BoE's rate hike follows the European Central Bank's decision last week to raise rates by a quarter-point to 3.5%, as well as rate hikes by the Swedish and Norwegian central banks earlier on Thursday.

While Britain faces challenges in combating inflation, given its slow decline from the 41-year high of 11.1% reached last year, other central banks also see obstacles. Bundesbank President Joachim Nagel described inflation as a "very greedy beast" on Wednesday, and U.S. Federal Reserve Chair Jerome Powell stated that further rate hikes remained a reasonable expectation, despite last week's pause.

The BoE maintained its previous guidance on future policy, indicating that if there is evidence of persistent pressures, additional tightening in monetary policy will be necessary.

The central bank also noted the sharp rise in short-dated British government bond yields, which anticipate an average Bank Rate of 5.5% over the next three years.

The BoE stated that it would closely monitor the impact of higher rates on mortgage costs, as well as the rising expenses in Britain's rental market.

Official figures released on Wednesday showed that consumer price inflation remained unchanged at 8.7% in May, while underlying inflation reached its highest level since 1992.

Last month, the central bank projected that inflation would decrease to slightly over 5% by the end of this year and fall below its 2% target in early 2025.