The rate increase is the Bank of England's eighth in a row and the biggest since a short-lived 1992 hike. It comes a day after the U.S. Federal Reserve announced a fourth consecutive three-quarter point jump.
Central banks worldwide have struggled to contain inflation after initially believing price increases were fueled by international factors beyond their control. Their response has intensified in recent months as it became clear that inflation was becoming embedded in the economy, feeding through into higher borrowing costs and demands for higher wages.
Thursday's rate decision was the first since Truss' government announced 45 billion pounds ($52 billion) of unfunded tax cuts, which sent the pound plunging to record lows against the U.S. dollar, pushed up mortgage costs and forced Truss from office after just six weeks.
While most of Truss' program has been canceled, the fallout remains: Borrowing costs are higher for the government, companies and homeowners because of concerns about economic and political stability in Britain, the bank said.
Truss' successor, Rishi Sunak, has warned of spending cuts and tax increases as he seeks to undo the damage and show that Britain is committed to paying its bills. Sunak and Treasury chief Jeremy Hunt plan to reveal their economic plan on Nov. 17.
“The most important thing the British government can do right now is to restore stability, sort out our public finances, and get debt falling so that interest rate rises are kept as low as possible,” Hunt said.
The Bank of England expects inflation to peak at around 11% in the last three months of the year, up from 10.1% in September. Inflation should begin to slow next year, dropping below the 2% target within two years, the bank said.
The squeeze on people's incomes likely contributed to a 0.5% decline in gross domestic product in the three months through September, which may be followed by a 0.3% drop in the fourth quarter, according to the bank’s forecast.
The projections are based on financial market data suggesting the key interest rate will rise to 5.25% by the third quarter of next year. The bank’s survey of financial professionals forecasts a lower peak of 4.5%, which would shorten the recession.
Bailey said there is uncertainty about how far and how fast the bank will boost interest rates because of volatility in natural gas prices and the country's tight labor market.
The war in Ukraine boosted food and energy prices worldwide as shipments of natural gas, grain and cooking oil were disrupted. That added to inflation that began to accelerate when the global economy began to recover from the COVID-19 pandemic.
Europe has been particularly hard hit by a jump in natural gas prices as Russia responded to Western sanctions and support for Ukraine by curtailing shipments of the fuel used to heat homes, generate electricity and power industry and European nations competed for alternative supplies on global markets.
Wholesale gas prices in the U.K. increased fivefold in the 12 months through August. While prices have dropped more than 50% since the August peak, they are likely to rise again during the winter heating season.
The British government sought to shield consumers by capping energy prices that are fueling inflation. After the turmoil from Truss' economic policies, Hunt limited the price cap to six months instead of two years, saying the program would be focused on only the neediest households beginning in April.
That injected another degree of uncertainty into the bank’s inflation forecasts.
But the economy will recover, Bailey said.
“We cannot pretend to know what will happen to gas prices. That depends on the war in Ukraine,’’ Bailey said. “But from where we stand now, we think inflation will begin to fall back from the middle of next year, probably quite sharply. To make sure that happens, bank rate may have to go up further over the coming months.''