The Bank of England has raised interest rates for the first time in more than three years and warned that further hikes are likely if the Iran war is not resolved.
At its latest meeting, the Monetary Policy Committee (MPC) decided to increase the Bank's base rate to 4% from 3.75%. It is the first time that borrowing costs have gone up since August 2023.
All members of the nine-person committee voted for a hike, although one member, Catherine Mann, preferred a bigger jump of 0.5 percentage points.
Inflationary pressure from energy prices
The MPC said it needed to take action to control rising inflation in the UK economy, which was being pushed higher by the impact of the US and Israel's ongoing conflict with Iran on global energy and fuel prices.
Governor Andrew Bailey said: "There is now enough inflationary pressure in the pipeline caused by the rise in energy prices, that an increase in Bank rate is warranted.
"Today's increase shouldn't be seen as the first in an inevitable long sequence of hikes.
"But, unless the conflict in the Middle East is resolved, neither does it seem likely to be the last increase."
It marks a strong signal from the Bank's boss that borrowers are heading for a bigger squeeze at a time when the cost of living is rising.
Households face price rises
The MPC said many companies had so far been absorbing higher energy costs into their profit margins or had hedged against large spikes since the war began around nine months ago.
But it warned that such "buffers would only prove temporary and these cost pressures would eventually pass through into higher consumer prices if the energy shock persisted".
This means that households could face price rises in shops for things like food, drink and other goods and services.
Interest rates are typically increased in a bid to bring down the rate of inflation, amid hopes that higher borrowing costs will weigh on demand and therefore cause firms to limit price increases.
Inflation expected to peak at around 5%
The Bank of England said on Thursday that it currently expects inflation will continue to accelerate in the coming months before peaking at "around 5%" in the second quarter of 2027.
It is then likely to steadily fall until it reaches the central bank's 2% target in the third quarter of 2028.
The projected rise in the cost of living comes despite efforts from Andy Burnham's Government to support households in last week's budget.
Bank research indicated that measures from the Budget, such as the removal of VAT from household electricity bills, are likely to reduce the inflation rate by around 0.25% in the second quarter of next year.
Energy bills and food prices to rise
The inflation spike is primarily driven by higher energy prices, linked to the intensification of the conflict in the Middle East in recent months.
Household energy bills are set to be a particular driver of inflation, with expectations that regulator Ofgem will increase its price cap for household bills by almost 25% to an average annual bill of £2,150 in January.
The Bank's report indicated that higher energy costs could feed further into supply chains by next year, as some firms see their hedged energy prices unwind.
It predicted that British households will also face more expensive food, with food inflation expected to rise as high as 4.8% next year. This was linked to higher energy costs for manufacturers as well as potential supply chain pressure linked to the El Nino weather system.
UK economy growth forecast upgraded
Nevertheless, the Bank said the UK economy has been more resilient than previously predicted in recent months. It said higher business investment, partly linked to AI, helped to drive stronger growth so far this year.
The Bank said the UK economy is on track to grow by 1.6% this year, up sharply from a previous forecast of 1.1%. The economy is then likely to see growth ease to 1.3% amid pressure from higher inflation, but this is still above the 1.1% growth projected in July.
However, the Bank said it downgraded its growth forecasts for 2028 and 2029 as elevated inflation and interest rates weigh on potential demand.
