The Bank of England (BoE) is likely to join the global rate-hiking cycle when it meets next week, even if it is a little late to the party. The more interesting question is what happens next. Until recently, the BoE faced an uncomfortable trade-off between tackling inflation and supporting a weak economy. That trade-off has largely disappeared.

Growth has been stronger than expected, the labour market is improving and higher energy prices are pushing inflation further above target. With fewer reasons to wait, we expect the Monetary Policy Committee (MPC) to raise rates from 3.75% to 4.00% on 5 November, with a 7–2 vote in favour of a hike and a substantially more hawkish message.

We expect another 25-basis-point increase in February, taking rates to 4.25%. But that is where we part company with markets. Our base case is that inflation will peak and growth will slow sufficiently enough for the Bank to keep rates on hold for the rest of 2027. Unless energy prices rise much further, or higher inflation feeds more clearly into wages, we think markets are overestimating how far interest rates will ultimately need to rise.

Why the Bank of England is set to raise interest rates in November

Almost all the evidence since the MPC’s last meeting points to a rate hike next week.

Higher energy prices pushed inflation to 3.5% in September, 0.5 percentage points above the MPC’s July forecast. We now expect inflation to rise above 4.5% in the new year, slightly higher than in the MPC’s adverse scenario.

Granted, the MPC does not need to respond mechanically to higher energy prices, particularly as higher energy bills squeeze households’ real incomes and, in turn, drag on growth. However, we think the case for looking through the shock is now much weaker.

UK economic growth and stabilising labour market strengthens the case for higher interest rates

The economy has been much stronger than the MPC expected. GDP grew by 0.1% in August and is likely to have expanded by around 0.7% in Q3, comfortably above the MPC’s September forecast of 0.4%. In addition, the PMI rose from 52.0 to 53.1 in October, suggesting that growth will hold up in Q4 rather than slow to a crawl. This sustained improvement suggests that monetary policy may be less restrictive than the MPC previously assumed.

What is more, stronger growth is now feeding through to hiring. The unemployment rate fell from 4.9% to 4.7% in August, payrolls rose by 13,000 in September and the employment PMI climbed above 50 for the first time in more than two years in October. Taken together, these indicators suggest that the labour market is stable or even improving.

That combination of resilient demand and a firmer labour market raises the risk of second-round effects. Firms will find it easier to pass higher costs on to customers, while workers will be in a stronger position to bargain for higher wages.

Indeed, MPC member Megan Greene recently stated that “our broad range of wage indicators suggest there is less slack in the labour market than we thought (...) this suggests the risk of second-round effects taking hold is higher.”

If second-round effects materialise, inflation will remain elevated for longer. We therefore think the MPC will raise rates in November to help limit their emergence and avoid falling behind the curve.

Taken together, higher inflation and a stronger economy mean the MPC currently faces no trade-off between tackling inflation and supporting growth. It has therefore run out of reasons to justify another hold.

We expect a hawkish pivot, with a 7–2 vote in favour of a 25-basis-point hike in November.

How high could UK interest rates go in 2027?

Inflation accelerating to above 4.5% early next year will cement the case for another rate hike in 2027, probably in February, taking interest rates to 4.25%. Our base case is that inflation will have peaked by February and growth will have slowed significantly, allowing the MPC to keep rates on hold for the rest of the year.

There was very little in yesterday’s Budget that the MPC will need to factor in. The measures announced will reduce inflation next year by around 0.1–0.2 percentage points, but that is inconsequential in the context of inflation rising above 4.5%. What is more, slightly looser fiscal policy over the next couple of years would, if anything, be mildly hawkish. Overall, the Budget did nothing to change the outlook for rates over the next year.

Energy prices remain the key risk to the interest rate outlook

Of course, much of the outlook beyond February depends on what happens over the winter. A further rise in energy prices, especially natural gas prices, would probably lead us to factor in a third hike next year. Likewise, evidence that higher inflation was being reflected in pay deals would also make a third hike more likely.

However, we doubt the Bank will need to raise rates to almost 5%, as markets currently expect. Admittedly, current pricing includes a premium for the risk of further increases in energy prices, but we think it would take a much larger rise than currently anticipated to push interest rates that high.

UK interest rate outlook: what happens next?

A rate hike next week looks nailed on. Stronger growth and a falling unemployment rate mean there is no longer a trade-off between supporting a weak economy and tackling high inflation. That makes the decision relatively straightforward for the MPC. The latest surge in energy prices has also removed the luxury of waiting and means there is likely to be at least one additional rate hike next year.

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