The Bank of England has kept interest rates on hold as it warned a continuation of the bitter fighting in the Middle East could force it to raise borrowing costs amid mounting fears over inflation.
It also announced a surprise plan to sell billions of pounds in UK government bonds back to the Treasury to avoid fuelling turbulence in the gilt market, a decision that could have significant consequences for the public finances before next month’s budget.
As the fallout from war in the Middle East fuels a rise in energy prices, the Bank’s monetary policy committee (MPC) voted by a majority of six to three to keep its base rate unchanged at 3.75%.
However, the Bank said the increasingly probable prospect of a lengthy war fanning intense volatility in global markets had dramatically raised the chance of it putting up borrowing costs in future.
Andrew Bailey, the Bank’s governor, said: “So far higher global energy costs have had a limited effect on price and wage setting in the UK.
“But the longer this volatility persists, the bigger the impact it will have on inflation, and the more likely it is we will need to raise [the] Bank rate to ensure that inflation falls back to our 2% target.”
With Threadneedle Street under pressure to guard against high rates of inflation becoming entrenched, City traders predict a quarter-point rise in borrowing costs from as early as November with three more increases to 4.75% likely next year.
The sharp rise in global energy prices prompted the US Federal Reserve to raise interest rates on Wednesday for the first time since 2023, after a decision last week by the European Central Bank to raise eurozone borrowing costs.
The Bank said inflation was on track to reach 4% by early next year, as the war-driven rise in energy prices hits households.
Official figures on Wednesday showed inflation rose to 3.1% last month from 2.9% in July as the escalating hostilities in the Middle East drove up the average price of petrol and diesel by almost a quarter.
It came after Andy Burnham said he was prepared to take “difficult decisions” to tackle high inflation and keep the economy on track and would take action at next month’s budget on the cost of living.
However, the MPC said the economy was showing signs of resilience and there was not yet a need to take action on borrowing costs because there had been “little evidence so far of material second-round effects” – when inflationary pressures push businesses and workers to demand higher prices and pay settlements.
There were also signs of weaker food price inflation despite the surge in energy prices triggered by the Iran war, it added.
Against a volatile backdrop in global financial markets, Threadneedle Street also announced updated proposals for the winding down of its financial crisis-era quantitative easing programme, which had involved the buying of £895bn of UK government bonds at its peak.
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In a surprise move, the Bank said it planned to sell £146bn of bonds to the Treasury, at a pace of about £20bn a year until 2034, in a plan that requires signoff from the chancellor, John Healey, next April. The Treasury’s Debt Management Office (DMO) would then sell bonds to cover the government’s financing commitments, including this buyback.
The rationale is that the Bank holds long-term bonds where investor demand is dwindling, whereas the DMO would have the capacity to cover the buyback by issuing shorter-term debt.
The process will be used to complete Threadneedle Street’s “quantitative tightening” programme – which has involved the sale of gilts held on its books since 2022, which has reduced its holdings to about £488bn.
The Bank said it would retain about £120bn of bonds, which were needed to back the issuance of notes and coins circulating in the economy.
Leaving about £222bn of bonds, it said this amount would be disposed of by allowing maturing debts to expire, and through active sales to the state if a deal was agreed. The Bank said it would pause its QT programme until a deal was finalised, and that it would resume sales to City investors if an agreement could not be reached.
In a letter to the chancellor, Bailey said the arrangement “preserves the independence of monetary policy” and would “maximise value for money by minimising cost and risk over the lifetime” of the QT programme.
It came as the Office for National Statistics also upgraded its estimates for the UK’s productivity growth, in a boost for Healey as he prepares for the budget.
The UK government’s borrowing costs and the pound fell slightly on Thursday after the decision. The central bank added that it would halt sales of long-dated gilts entirely. The 10-year gilt yield fell by six basis points to 5.243%, the lowest level in a week.