Bank of England warns of earlier and larger rate hikes for the UK

• Sterling spiked against the dollar on the news as higher rates in an economy tend to favor the local currency with the anticipation of more investment.
• Governor Mark Carney insisted in his subsequent press conference that any rate moves would be gradual.
• He added that the message to markets was that U.K. interest rates could move somewhat sooner and to a somewhat greater extent than previously expected.

The Bank of England (BOE) has signaled the need for interest rate rises earlier and potentially larger than previously predicted, preparing markets for impending higher borrowing costs.

In its first meeting of 2018, the Bank's Monetary Policy Committee (MPC) judged that, were the economy to move broadly in line with its projections, "monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period," than anticipated during its last report in November. This would be required to "return inflation sustainably" to its target and over a "more conventional horizon," the report said.

Sterling spiked against the dollar on the news as higher rates in an economy tend to favor the local currency with the anticipation of more investment. The pound broke above 1.400 against the greenback after trading close to 1.388 before the announcements.

At the same time as the inflation report, the Bank voted unanimously to keep interest rates unchanged on Thursday.

The rate decision and hawkish comments come on the back of significantly improved global growth, a modest improvement to the U.K.'s growth outlook and increasing domestic cost pressures as wages look to rise.

Rate moves will be 'somewhat sooner'

The BOE noted that the market believes that interest rates could reach 1.2 percent by 2021, suggesting three rate hikes in that period. However, this would still leave inflation above target which hinted at a possible hiking cycle that was quicker than investors were expecting. BOE Governor Mark Carney insisted in his subsequent press conference that any rate moves would be gradual.

He added that rates would not move more rapidly, and reiterated this point on several occasions when quizzed by journalists on Thursday. However, he added that the message to markets was that U.K. interest rates could move somewhat sooner and to a somewhat greater extent than previously expected.

"We're not going to tie our hands to a specific path for rates going forward. We are reiterating that these interest rate cycles are unlike those we would've experienced in the past," he told the media.

Analysts at Barclays said that the BOE's comments and projections seemed to point towards a hike in August, but believed the central bank could also consider a hike in May.

"(But it) would then need to argue much more convincingly that the British economic and political backdrop supports such a step change," Fabrice Montagne and Sreekala Kochugovindan said in a research note.

Inflation pressures

The MPC once again stressed its remit to strike a balance between providing an accommodating monetary policy that supports economic activity while at the same time returning the U.K. to a target inflation rate of 2 percent.

U.K. inflation is still far above this target, and in November hit a five-year high of 3.1 percent, mainly due to the stark depreciation in sterling since the June 2016 Brexit vote. It has since moved to 3 percent.

A higher outlook for wages as well as the low level of "slack" in the economy, appears set to continue squeezing prices and propping up inflation.

But the Bank believes inflation will gradually subside over its three-year forecast, though will remain around current levels for at least the next few months as domestic cost pressures continue to build, energy prices rebound and imports remain expensive thanks to the weaker pound. It does not project a return to the 2 percent target in the next three years.

Incoming data for the country's economy has still been mixed since the MPC's last meeting in December 2017, when the committee voted unanimously 9-0 to leave rates unchanged while expressing its intention of "further modest increases in Bank Rate … over the next few years."

The BOE hiked rates in November of 2017 for first time in over a decade, voting to increase the benchmark rate from 0.25 percent to 0.5 percent as part of what it called a "gradual and limited" cycle to counter inflation.

Lagging behind its peers

While seeing the best signs of recovery since the June 2016 Brexit vote, the country's growth still lags behind that of its main trading partners amid a broadly-based global upswing. Fears remain that domestic politics and uncertainty over Brexit outcomes could still impede a re-joining of this faster global growth.

As in previous inflation reports, the Bank emphasized that … "Developments regarding the United Kingdom's withdrawal from the European Union — and in particular the reaction of households, businesses and asset prices to them, remain the most significant influence on, and source of uncertainty about, the economic outlook."