LONDON — The Bank of England on Thursday imposed back-to-back interest rate hikes for the first time since 2004 and began the process of quantitative tightening.

Markets had broadly expected the 25 basis point rate increase, which the Monetary Policy Committee voted for 5-4 and which takes the main Bank Rate to 0.5%, as the central bank strives to contain soaring inflation. Four members voted to increase rates by 50 basis points to 0.75%.

The Bank fired the starting gun on rate rises in December, hiking its main interest rate to 0.25% from its historic low of 0.1%.

Since then, data has shown U.K. inflation soared to a 30-year high in December as higher energy costs, resurgent demand and supply chain issues continued to drive up consumer prices.

The Bank of England on Thursday also raised its inflation forecast to an April peak of 7.25% from the 6% projected in its December report.

The labor market recovery has remained robust in the U.K., with 184,000 staff added to payrolls in December, putting the total estimate of payrolled employees 409,000 higher than its pre-Covid level.

The Bank of England stuck with past guidance to the market to expect quantitative tightening once the Bank Rate reached 0.5%, reducing its government and corporate bond purchase target by ceasing to reinvest maturing assets. A program of corporate bond sales is set to be completed no earlier than late 2023, which would fully unwind the central bank’s stock of corporate bond purchases.

In its report, the MPC said any further tightening of monetary policy will depend on the medium-term prospects for inflation.

“The MPC judges that, if the economy develops broadly in line with the February Report central projections, some further modest tightening in monetary policy is likely to be appropriate in the coming months,” it said.

“The Committee continues to judge that there are two-sided risks around the medium-term inflation outlook, primarily from wage developments on the upside and from energy and global tradable goods prices on the downside.”

Sterling was up 0.2% against the dollar shortly after the decision, while U.K. bond yields shot up. The 10-year gilt yield hit its highest point since early 2019 at 1.345%, gaining nine basis points on the day. The two-year gilt yield rose to around 1.13% and 30-year gilt yields climbed to 0.31%.

Anna Stupnytska, global macro economist at Fidelity International, said with inflation surging and proving more persistent than policymakers initially presumed, the Bank of England is “taking no chances” of risking de-anchoring inflation expectations.

“Concerned about its credibility as an inflation targetter, the BOE is the first major central bank embarking on the inflation fighting experiment in the environment of slowing growth momentum and continued dislocations in the energy markets, fueling the cost of living crisis as real incomes are getting squeezed,” Stupnytska said.

“Partly because of this challenging backdrop, we believe the BOE hiking trajectory is likely to be shallower than current market pricing of nearly 5 hikes in 2022, with growth challenges and the high debt burden acting as key constraints.”

Britain’s energy regulator on Thursday increased its energy price cap by 54% as supply side problems continue to exert upward pressure on costs.

Given inflation remains the dominant narrative, Stupnytska said the risk of a policy mistake from the central bank remains “uncomfortably high.”

“As the Fed joins the BOE in the hiking cycle later this year, market vulnerabilities will likely come in sharp focus as the policy punchbowl starts getting withdrawn.”

The ‘elephant in the room’

Many economists were surprised that four members of the MPC voted for a 50 basis point hike in interest rates, and suggested it could point to a more hawkish approach as the Bank attempts to wrestle inflation back toward its 2% target.

“Investors and households have got used to quite gradual increases in the level of rates, so the fact that so many policy makers thought a large increase was appropriate today will put markets at notice that more sudden shifts in policy are possible, which will increase uncertainty and volatility,” said Luke Bartholomew, senior economist at Abrdn.

However, with energy prices continuing to soar, the Bank will be wary of inflicting too much pain on already-struggling households, especially those on low income.

Hinesh Patel, portfolio manager at Quilter investors, said energy prices will remain “the elephant in the room” and the Bank will have to hope that they don’t keep escalating.

“The squeeze for the real economy ahead is real and can already see the heart-breaking stories in the news. The Chancellor, like during the pandemic, will need to be ready to step up when required and act in tandem with the BoE to prevent the economic recovery being choked off,” Patel said.

“For investors, what this rate rise means they will need to be braced for more volatility in fixed income markets and avoid it where possible. Owning companies that can deal with price shocks will ultimately prevail, meaning quality will remain crucial while we navigate this rocky period.”