The Bank of England stunned homebuyers, businesses and the City of London yesterday with an unexpected rise in interest rates to combat the threat of rising inflation.
The quarter-point increase in the base rate to 4.75 per cent was its first for two years, and the third year in a row it has moved interest rates in the month of August.
Shares slumped in London, while the pound and interest rate futures rose sharply as traders bet on a record number of sterling options to price in further rate rises.
The FTSE 100 index closed down 93 points, or 1.6 per cent, at 5,838.
The move was also seen as a declaration of self-confidence by the Bank's Monetary Policy Committee (MPC), which many analysts said would feel unable to change rates while still two members short of its full complement of nine economists.
Business leaders, housing bodies and trade unions reacted with surprise and anger at the decision, with some accusing the Bank of putting the hopes of a sustained economic recovery at risk.
"The Bank has jumped the gun with this decision," said Martin Temple, director general of the manufacturers group EEF, who branded the move as "wrong". He said there was no sign that soaring energy costs had fed through to increases in wages and prices that would be needed to fuel a sustained increase in inflation.
"Business will not look kindly if this rise has to be quickly reversed later in the year," Mr Temple said.
This view was echoed by the TUC, whose assistant general secretary Kay Carberry described it as a "double blow" for people with mortgages.
"With manufacturing still struggling and unemployment creeping up, the country needs rates to stay low," she said.
Representatives of the housing industry said the increase in borrowing costs would only add to the cost burden for homebuyers already struggling with soaring utility and council tax bills.
Paul Smith, chief executive of haart estate agents, said: "This is particularly bad news for first-time buyers, who are finding it increasingly more difficult to get on the property ladder."
Several major lenders including Nationwide building society, Abbey National, HSBC and Northern Rock said they were reviewing their position.
The Council of Mortgage Lenders said that the "timely" rise in rates had limited the extent for even higher increases in the future.
In its statement, the Bank of England said the economy had grown above trend for the last few quarters, leaving a "small" margin of spare capacity in the economy to absorb price pressures.
"Against the background of firm growth, limited spare capacity, rapid growth of broad money credit, and with inflation likely to remain above target for some while, the MPC judged an increase... was necessary to bring inflation back to target in the medium term," it said.
The vast majority of City economists had expected the Bank to leave rates on hold yesterday, and several said they did not expect the MPC to follow it up with further rises.
Philip Shaw, chief economist at Investec, who bet on a rise, said: "The pre-emptive strike in rates should be seen as a 'stitch in time' policy and should prevent rates from having to go up again."
Alan Castle, UK economist at Lehman Brothers, said the Bank's latest economic forecasts, which will be published next week, would probably show it had raised its inflation projections. "The message from the May inflation report was that some tightening of policy was needed to keep inflation on track to meet the target, but not until spring 2007. The obvious implication is that it has upgraded its projections," he said.
But others focused on a warning by the Bank that it feared inflation would remain above target "for some while".
John Butler, UK economist at HSBC, said: "This is a hike, and depending on the inflation outlook, the door is still open for more."
The European Central Bank (ECB), which sets interest rates for 300 million people, also raised borrowing costs yesterday, and signalled there were more rises in the pipeline.
Jean-Claude Trichet said the ECB would watch inflation risks very carefully after it raised rates to 3 per cent, raising expectations of another increase in October.
Nick Stamenkovic, senior economist at RIA Capital Markets, said: "The clear message is that they remain in tightening mode and concerned about inflation. Rates will head to 3.25 per cent by the year-end."Reuse content