By David Milliken
LONDON (Reuters) -The Bank of England is set to raise interest rates for a 13th time in a row on Thursday, a day after inflation data came in higher than expected once again, with investors split on just how big the new hike will be.
Economists polled by Reuters last week were unanimous that the BoE would raise rates to 4.75%, their highest since 2008, from 4.5%.
But after inflation held at 8.7% in May, investors were pricing a 45% chance that the BoE would opt for a bigger move and raise rates by half a percentage point, even as fears mount about the hit to mortgage-holders and the risk of a recession.
"I think it's a very finely balanced decision," said Tomasz Wieladek, chief European economist at U.S investment firm T. Rowe Price, who predicts at least three of the Monetary Policy Committee's nine members will vote for a half-point hike.
Britain's economy, which has been hit by the shock of Brexit as well as the COVID-19 pandemic and the surge in gas prices caused by Russia's invasion of Ukraine, has dodged a widely expected recession so far in 2023 though growth looks set to be a minimal 0.25% this year, according to the BoE's forecasts.
Unlike most other big rich economies, output has barely recovered to pre-pandemic levels.
However, two inflation readings since the BoE's last rate hike in May have both been higher than expected.
"It's pretty clear that our inflation problem is a bit worse than elsewhere," Charles Bean, a former BoE deputy governor, told BBC radio, adding he would vote for a half-percentage point hike now if he were still at the central bank.
Another former BoE rate-setter, Martin Weale, said Britain's weak productivity growth and its shortage of workers meant a recession was on the cards as interest rates go up.
"Reducing demand in the economy is quite likely to lead to a recession," he told Sky News.
Households are now also seeing their mortgage bills rise, with average new two-year fixed-rates rising to 6.15% on Wednesday in anticipation of further rate hikes.
Financial markets were estimating that the BoE would keep raising rates until they hit 6% - their highest since 2001 - more than the U.S. Federal Reserve which is seen tightening by just a quarter point more and the European Central Bank which investors expect may move twice more.
"The UK has a uniquely bad inflation problem," Krishna Guha, a vice chairman at U.S. investment banking advisory firm Evercore, said.
Prime Minister Rishi Sunak - who has pledged to halve inflation this year in an attempt to win back voter support ahead of a national election expected in 2024 - has said he fully backs the BoE's efforts to tame prices.
"I feel a deep moral responsibility to make sure the money you earn holds its value," Sunak will say at an event on Thursday, according to advanced extracts released by his office.
Sky News said unnamed members of the government thought Governor Andrew Bailey was failing at his job.
FALLING FASTER?
The central bank last month forecast that consumer price inflation, which peaked at a 41-year high of 11.1% in October 2022, would fall to just over 5% by the end of this year and be below its 2% target in early 2025.
A significant inflation drop is almost inevitable as energy prices come down from last year's peaks.
But incoming BoE policymaker Megan Greene - who will join the MPC next month - said last week that getting inflation from 5% to 2% may prove a tougher task than the initial fall.
Core inflation - which strips out more volatile prices to show an underlying trend - rose to a 31-year high in May.
Wieladek, who worked at the BoE from 2008 to 2015, said wages looked set to keep on growing at an annual rate of around 6%, almost twice the level consistent with 2% inflation, given the shortage of workers available to many employers.
In previous decades, British wage growth has only slowed after a large rise in unemployment, and Wieladek estimated the BoE would need to engineer a recession that pushed unemployment up to 6.0%-6.5% from its current 3.8% to achieve this now.
"Unfortunately, the Bank of England is in a situation where they will have to hike until something breaks," he said.
Most economists are less gloomy and think rates are more likely to peak near 5% as recent falls in energy and raw material costs affect the price of other goods and services.
"Market pricing for a lot more rate hikes could reverse quite quickly - especially if weaker inflation is ultimately allied with easing wage pressures," strategists at Nomura wrote.