BOE surprises with first hike in crisis to curb inflation

The first major central bank to hike its benchmark since the pandemic began opted to lift borrowing costs by 15 basis points to 0.25%, delivering an increase that no other Group of Seven central bank has made since the start of the crisis.

The pound rallied as much as 0.8% while U.K. 10-year yields jumped 5 basis points after the decision. Traders now see the BOE's key rate rising to 1% by September. The FTSE 100 stock index pared gains.

"Another hike in February of 25 basis points is well in the cards," said Fabrice Montagne, chief U.K. economist at Barclays. "If delivered, the MPC would also be in a position to start running down its balance sheet with bonds starting to mature out of its portfolio in early March."

Markets are current pricing in another 20 basis points of increases in February -- implying an around 80% chance of a move to 0.5% at that meeting. That would allow the BOE to immediately bring an end to its policy of reinvesting its expired QE bond holdings, allowing as much as 37 billion pounds of government debt to roll off its balance sheet by the end of 2022.

Officials led by Governor Andrew Bailey voted 8-1 for the increase, with Silvana Tenreyro dissenting in favor of no change. Policy makers said more "modest" tightening is likely to be needed as inflation heads toward a peak likely to be around 6% in April.

"Worries about inflation trumped concerns about omicron at the Bank of England's December meeting. The move is a gamble -- it's possible the economy will shrug off the new variant of Covid-19, but no one knows for sure. Assuming the virus doesn't slow the economy materially, we expect the next move in May, although there's a small risk the BOE hikes again in February," Dan Hanson of Bloomberg Economics wrote.

While the decision surprised investors, it was consistent Bailey's guidance. In October, he signaled that rates would need to rise to address inflation. Later, he set out his concerns that markets seemed to think that policy makers were prioritizing growth over their inflation-fighting remit.

In a speech earlier this month, Ben Broadbent, the deputy governor, added that the BOE's job was to focus on the medium-term risks. The decision to raise rates in the context of surging inflation and flagging growth is a clear statement of the BOE's priorities. The focus on medium term price risks over the impact of omicron, which is likely to be short term, is consistent with Broadbent's stance.

The U.S. Federal Reserve already set a hawkish tone on the eve of the BOE announcement by signaling three rate hikes next year and accelerating the wind down of its stimulus program, while Norway kept up its own tightening effort on Thursday with its second increase this year.

The BOE's precipitous shift into tightening mode will surprise the large majority of economists who anticipated no change, and investors who were pricing in around a 40% chance of a move. The outcome was the second in a row featuring a surprise after November's decision to stay on hold wrong-footed financial markets.

"The Bank of England's decision to raise interest rates was surprising given mounting uncertainty over the economic impact of the Omicron variant," said Suren Thiru, head of economics at the British Chambers of Commerce. "While today's rate increase may have little effect on most firms, many will view this as the first step in a longer policy movement."

The BOE hike is a response to the danger posed by surging prices gains, with a report this week showing inflation jumped to 5.1% in November -- more than double the central bank's target -- and a separate report Tuesday showing U.K. companies added to payrolls at a record pace.

Considering that backdrop, Goldman Sachs Chief European Economist Jari Stehn told Bloomberg Television just hours earlier that an outcome of no change was "not a done deal," even though it was his main expectation.

The decision to move now is all the more remarkable since the country is in the grips of a new coronavirus wave driven by the more infectious omicron variant, which has pushed daily case loads in the U.K. to the highest recorded total since the pandemic began.

The danger that poses in potentially overwhelming the country's health services is such that Prime Minister Boris Johnson's government has reintroduced some curbs on activity, with more possible in coming days and weeks if the outbreak can't be quelled.

By moving now, the BOE heeded a warning this week from the International Monetary Fund, which cautioned against policy inaction on inflation.

The increase is the first from the BOE since 2018 and comes a day after officials wrapped up their pandemic-era quantitative easing plan. The buying has left the central bank's holdings of government bonds at 875 billion pounds ($1.2 trillion), from 435 billion pounds before the crisis hit.

The central has only hiked rates once in December in the past 45 years, and never since it was granted independence in 1997.

Outside of emergency actions during the pandemic, it's also the first time officials have moved at a meeting that isn't a so-called "Super Thursday"-- the nickname for the quarterly events when the BOE simultaneously publishes its decision, minutes and forecasts -- since they were introduced in 2015.

The European Central Bank on Thursday set out its plan to move on from emergency stimulus, saying it will expand its regular bond purchase for half a yera to smooth a transition toward phasing out its debt-buying program. Officials in Frankfurt confirmed their 1.85 trillion-euro ($2.1 trillion) pandemic measure, known as PEPP, will wind down as planned in March.

To cushion that halt in emergency purchases, they temporarily boosted their conventional bond-buying tool. President Christine Lagarde has been at pains however to persuade investors that a rate increase in the euro zone isn't going to happen any time soon.