The Bank of England has warned that it expects the UK economy to shrink in 2022 as interest rates are raised to curb rising prices.
Interest rates have been increased from 0.75 per cent to one per cent, the fourth consecutive rise since December.
This sees interest rates reach their highest level since 2009, and comes as the Bank tries to establish a grip on inflation.
Inflation has reached a 30-year high of seven per cent and is projected to hit 10.25 per cent before the end of 2022, up from previous year-end estimates of eight per cent.
Spiralling inflation is being driven by sharp rises in fuel, energy and food prices, which have been exacerbated by the Russian invasion of Ukraine. The energy price cap also increased in April and is expected to go up again in October.
The Bank of England’s Monetary Policy Committee [MPC] which oversees fiscal policy and sets interest rates, said: “Global inflationary pressures have intensified sharply following Russia's invasion of Ukraine. This has led to a material deterioration in the outlook for world and UK GDP growth.”
Before Russia invaded its neighbour, prices in the UK were already increasing as a result of the Covid-19 pandemic and inflation soared to seven per cent in the year to March, significantly exceeding the Bank of England’s target of two per cent.
Russia is among the world’s largest oil and gas producers and its subsequent military incursion on Ukraine - a major exporter of grain - has driven up the prices of fuel, energy and foodstuffs even further.
The resulting squeeze on household finances has limited consumer spending power, which is stunting economic growth as more and more people spend less.
The Bank hopes that by increasing interest rates and thereby making it more expensive for consumers and businesses to borrow, the demand for goods and services will ease and prices will reduce as a result.
However, economists fear that even increasing interest rates will have little influence in the wake of rising prices, which means that the interest rate hike comes with its own set of risks. The latest rates increase will also see two million UK homeowners face immediate hikes in their monthly mortgage repayments, while other loan repayments also become greater.
Yet, Bank of England governor Andrew Bailey insists that any risk arising from raising interest rates paled in comparison to letting inflation spiral beyond control.
He said: We have been very careful in our response, taking into account the scale of the shock to the economy.”
In the wake of its latest move, the MPC has downsized its growth outlook for 2023 from one per cent to 0.25 per cent and expects a 0.25 per cent contraction in the UK economy over 2022.
The MPC said: “UK GDP growth is expected to slow sharply over the first half of the forecast period. That predominantly reflects the significant adverse impact of the sharp rises in global energy and tradeable goods prices on most UK households' real incomes and many UK companies' profit margins.”
While a 2022 contraction would leave the UK at risk of a recession, the Bank has stopped short of saying that sliding into one is likely, given that this would require two consecutive quarters of economic shrinkage.
Indeed, Bailey opted to describe the projection for the economy as a “very sharp slowdown” rather than a recession.
Based on market forecasts that interest rates will hit 2.5 per cent by mid-2023 before subsiding, the MPC expects inflation to peak at 10.25 per cent in 2022 before prices begin to stabilise and it recedes to 3.5 per cent in 2023 and down further to 1.5 per cent the following year.
Yet, the economic slowdown will gradually force unemployment up, with forecasts suggesting it will hit approximately five per cent in 2024.
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