The Bank of England has raised interest rates for the first time since the start of the coronavirus pandemic, as concerns about rising inflation outweighed worries about the negative effect of the omicron variant on the economy.
The central bank's monetary policy committee (MPC) lifted rates from 0.1% to 0.25%.
Among the immediate effects on financial markets, shares in the UK's big banks shot up, with Lloyds Banking Group PLC (LSE:LLOY) rising 4.6%, Barclays PLC (LSE:BARC) 4.3%, NatWest Group PLC (LSE:NWG) 3.4% and Virgin Money UK PLC (LSE:VMUK) 3.3%.
The MPC members voted eight to one to raise rates, while there was a unanimous vote to keep the asset purchase programme (quantitative easing/QE) at £875bn a month.
Explaining the decisions, the Bank said: "Since the November MPC meeting, the Omicron Covid variant has emerged. It appears to be spreading rapidly within the United Kingdom and around the world...
"The level of global GDP in 2021 Q4 is likely to be broadly in line with the November Report projection, but consumer price inflation in advanced economies has risen by more than expected. The Omicron variant poses downside risks to activity in early 2022, although the balance of its effects on demand and supply, and hence on medium-term global inflationary pressures, is unclear. Global cost pressures have remained strong...
"At its November meeting, the Committee judged that, provided the incoming data, particularly on the labour market, were broadly in line with the central projections in the November Monetary Policy Report, it would be necessary over coming months to increase Bank Rate in order to return CPI inflation sustainably to the 2% target. Recent economic developments suggest that these conditions have been met. The labour market is tight and has continued to tighten, and there are some signs of greater persistence in domestic cost and price pressures. Although the Omicron variant is likely to weigh on near-term activity, its impact on medium-term inflationary pressures is unclear at this stage."
The committee said it judged that an increase in the Bank Rate was "warranted".
The Bank also cut its expectations for UK gross domestic product growth in the fourth quarter of 2021 by around half a percent since the November report, leaving GDP around 1.5% below its pre-Covid level.
On inflation, it noted that CPI inflation in November was up 5.1% on a year before, up from 3.1% in September, with a significant upside in prices for core goods and, to a lesser extent, services.
The Bank said it expects inflation to remain around 5% through the majority of the winter period, and to peak at around 6% in April 2022 as utility bill increases come through from the effect of elevated wholesale gas prices.
"CPI inflation is still expected to fall back in the second half of next year."
The MPC said it will review developments, including emerging evidence on the implications for the economy of the Omicron variant, as part of its forthcoming forecast round ahead of the February 2022 Monetary Policy Report, with a continued focus on the medium-term prospects for inflation.
"The Committee continues to judge that there are two-sided risks around the inflation outlook in the medium term, but that some modest tightening of monetary policy over the forecast period is likely to be necessary to meet the 2% inflation target sustainably. The Committee will reach its assessment on the balance of the risks to medium-term inflation in light of the relevant data as they emerge."
Market and analyst reaction
As well as bank shares, other market reactions included the pound, which jumped almost 1% to above 1.337 against the dollar from 1.3260 after the announcement, while the FTSE 100 retreated only minimally.
“The Bank of England took markets on the wrong foot... delivering an increase that no other G7 central bank has made since the start of the crisis," said Mike Owens, global sales trader at Saxo Markets.
“It seems that Bank of England is following the footsteps of the Fed and has finally succumbed to the pressure, biting the dust. But looking ahead, we think this is likely to be a two and done kind of a scenario, and then the central bank is likely to go into a long wait-and-see mode."
He said it put more pressure on the ECB, which in its meeting short afterwards laid out its plans for tapering its monthly asset purchases, which also followed a rate hike by Norway's central bank this morning.
Make UK, the trade body for manufacturers, said the rate rise "is the right move as it would be consumers who foot the bill in the long run if inflation is not brought under control".
Martin Beck, senior economic advisor to the EY ITEM Club, noted that the rate increase was modest and still left the policy rate below the pre-pandemic level.
"The direct economic impact should be small and made smaller still by the decline in the share of households with a mortgage and growth in the popularity of fixed-rate mortgages over the last few years," he said.
"But being the first rate rise for so long means the MPC’s decision carries more weight than the small addition to the cost of borrowing implies. And the novelty for people unused to a world of rising interest rates means the impact of today’s decision on the appetite to save or spend is more uncertain."
Having read the MPCs comments, Marc Ostwald at ADM Investor Services said the committee "effectively admits that the latest spike in inflation was effectively a bridge too far, and that the majority felt that they could no longer sit on their hands, even though the analysis on the economy and the inflation outlook is not materially different to November.
"While pre-judging the impact of the Omicron variant on the economy and inflation is indeed a fool's errand at this stage, it borders on the disingenuous to suggest as they do that the medium-term outlook for inflation has changed materially since the November meeting. In principle today's decision is effectively a tacit admission that they should have made this initial hike in November.
"A further rate hike in February is very clearly on the table, though there is clearly a great deal of ambivalence, in part because the risks to the outlook are indeed two-sided, but above all because the MPC is so reactive and sensitive to incoming data. The only thing that is clear is that they have no view on the medium-term rate trajectory, and markets should avoid taking any pronouncements from MPC members as an indication of policy intentions.
"While risk appetite clearly remains high at the current juncture, if a more adverse environment emerges in the New Year, GBP assets will probably need to factor in a larger risk premium," Ostwald concluded.
At Rabobank they agreed that the surprise announcement "suggests the MPC bottled it in November" but the sombre economic outlook "makes this hike even more hostage to fortune".
The Dutch bank says it is holding on to its forecast of "a much less aggressive" tightening cycle than the market is currently pricing, with another 25 bps hike "early next year".