The Bank of England (BoE) hiked UK interest rates by 0.5 percentage points to 3.5% in December, its ninth consecutive rate increase as it looks to battle soaring inflation.
The rise, which takes rates to their highest levels since October 2008, adds to existing consumer pressure by increasing mortgage and credit card rates, while deepening the UK's recession.
Threadneedle Street now expects UK GDP to decline by 0.1% in the final quarter of 2022, which is 0.2 percentage points stronger than expected, but would still show the UK entering a technical recession.
Interest rates stood at record lows of just 0.1% a little more than a year ago, thanks to the COVID pandemic ripping through the economy. But with inflation at 10.7% in the year to November, the Monetary Policy Committee (MPC) is aiming to bring it back down to its 2% target.
The MPC was not unanimous in its decision, voting 6-3 to raise the bank rate. There was a widening range of opinions, with two dovish members, Silvana Tenreyro and Swati Dhingra, voting to keep rates at 3% while one hawkish member, Catherine Mann, voted for a 75-basis point increase.
“Of the three major central banks, one could argue that the Bank of England has been the most dovish, particularly after it pushed back against market pricing for hikes at its last meeting in November,” Matthew Ryan, head of market strategy at Ebury, said.
However, since then, the pound (GBPUSD=X) has outperformed almost every G10 currency, including both the euro and the dollar, as UK financial markets stabilise after a turbulent period post-mini budget.
Sterling has rallied by around 15% off the late-September lows, while the US dollar index is down more than 8% from its peak two months ago.
Andrew Bailey, governor of the BoE, also recently admitted that runaway inflation is affecting lower income households harder as a larger proportion of their spending goes on essentials like food and energy.
Watch: What is a recession and how do we spot one?
So what can we expect from Threadneedle Street in 2023?
Economists have highlighted that there will be calls for less aggressive monetary tightening going forward due to weaker growth momentum.
The BoE is set to join the US Federal Reserve and the European Central Bank in slowing down the recent 0.75% pace of rate hikes.
Ben Laidler, global markets strategist at social investing network eToro, said: “All are now starting to see the light at the end of the high inflation tunnel as price rises start to peak and fall. This is the crucial first step towards a summit of UK interest rates around 4.25% early next year, and the start of rate cuts late in 2023.”
Deutsche Bank (DB) said it expects the bank rate to reach 4.5% by May next year, down from its previous projection of 4.75%.
Brian Coulton, chief economist at Fitch, said: “Taming inflation is proving to be harder than expected as price pressures broaden and become more entrenched. Central bankers are having to take the gloves off. That won’t be good for growth.”
The ratings agency now sees interest rates rising even further in 2023, with most experts agreeing that the BoE will ease up on the base rate in the second quarter of 2024.
“Our latest 4.75% peak forecast for the BoE has been revised up by 150bp since the previous GEO. We do not anticipate a pivot to rate cuts until 2024,” Fitch said.
Laith Khalaf, head of investment analysis at AJ Bell, said: “Clearly there are lots of factors which can move the interest rate peak up or down, but for now 4.5% looks a reasonable working assumption.
Meanwhile Simon Harvey, head of FX analysis at Monex Europe, said: “We think that further rate hikes will be limited, as the growth impact and financial stability risks stemming from a housing market correction will restrict the BoE from going much higher.
“The main risk to our forecast is that the adjustment in the energy price guarantee in April leads the BoE to hike by another 25bps in May to prevent inflation expectations from de-anchoring further.”
But what does this mean for consumers?
Both businesses and consumers are suffering from the sharp rise of goods and services, and homeowners have also seen their mortgage payments rise on the back of higher interest rates.
While the recent rise to 3.5% was expected, it will still be a worry to the 4 million mortgage holders already identified by the Bank as facing higher mortgage costs in 2023.
Read more: 2022: Year in review
This includes 670,000 households whose mortgage debt servicing costs after adjusting for cost of living spending will exceed 70% of their income, a trigger making them more vulnerable to experiencing payment difficulties.
Rates rises mean someone with a £200,000 tracker mortgage could be paying an extra £326 per month which is an annual increase of £3,912.
Watch: Will UK house prices ever fall?
Those on tracker or standard variable rate (SVR) mortgage deals will feel the most immediate pain.
Moneyfacts said a Bank rate rise of 0.5 percentage points on the current average SVR of 6.40% would add approximately £1,509 onto total repayments over two years.
“It’s going to make life more difficult if your borrowing is linked to the base rate, but the impact on fixed rate mortgages and savings is more complicated. We may well see the weird phenomenon of base rates going up while savings and mortgage rates drop,” Sarah Coles, senior personal finance analyst at Hargreaves Lansdown, said.
Although mortgage rates have been higher in the past, house prices are now at their most unaffordable level since Victorian times. Someone earning the average salary would now need to pay 8.5 times their salary to buy the average house, compared with around five times in the 1970s.
Alice Guy, personal finance editor at Interactive Investor, said: “There’s a toxic combination of high house prices and rising interest rates coming down the track. It’s a bleak picture for many homeowners who need to re-mortgage during 2023 and may find their repayments increasingly unaffordable.”
To make matters worse, higher mortgage payments will come on top of other soaring costs like fuel, food, and energy bills which are rising again in April.
Increasing interest rates are good news for people at retirement who may want to take a guaranteed income from their pension pot.
Pension annuities have hit their highest rates in more than a decade, so those near retirement could get a higher level of income.
Paul Bucksey, chief investment officer at Smart Pension, said: “Although these are significantly challenging times, people should try to keep saving into their workplace pension if they possibly can.
“Pausing contributions to a workplace pension means employers are likely to also pause theirs. This means workers will lose out on valuable ‘free’ employer contributions. Over time, this is likely to have a big impact on accumulated pension pots at retirement.”
On paper, rate rises are good for savers, with easy access rates continuing to inch up. At the moment, UK consumers can make up to 3% on savings if they are prepared to accept restrictions, and can expect accounts to start offering the same rate with more flexibility.
High street banks increased rates on their branch-based easy access accounts very fractionally at the start of December, and they may do so again.
Sarah Coles, senior personal finance analyst at Hargreaves Lansdown, said: “For savers, while we may well see easy access rates creep up as a result, for anyone with a branch-based easy access account from a high street giant, the rewards will be pitiful.
“Despite a year of rising rates, they’re still paying a fraction of 1%. And for those planning to fix their savings for a year or more, a strange phenomenon in the market could actually see those rates fall.”
She added: “For fixed rate deals, there’s not such good news, because this rate rise was already largely priced in, so there won’t be a big bump on the back of the announcement. In fact, we’re expecting to continue to see the most competitive rates gradually withdrawn, and the best rates fall.
“The market is repricing to take account of the fact that rates are expected to be lower later in the fixed term. However, you can still get one-year fixed rates at over 4.3% and two-year deals at 4.7%. And if the Bank of England’s earlier forecast for inflation at around 5% in 2023 and under 2% in 2024 holds true, you can beat inflation.”
A strengthening pound has economic advantages, including reducing import inflation, which could lead to price pressures that are not as bad as some expect as we move through 2023.
The pound has been trading steadily since the BoE’s announcement, and is hovering around $1.21.
It had already dipped back due to expectations that higher rates in the US may linger for longer, while UK rates might not go as high as previously expected as recessionary cold front moves in.