By David Milliken
LONDON (Reuters) - The Bank of England looks set to raise interest rates to 3.5% or more next week, but policymakers appear increasingly split on how much tightening is needed to tame double-digit inflation as the economy heads into recession.
Last month BoE Governor Andrew Bailey said further rate rises were likely to be necessary, though fewer than financial markets had priced in before that meeting, when investors were betting rates would reach 5.25% in mid-2023.
However, two policymakers who voted against November's three-quarter-point rise - the BoE's biggest rate hike in over 30 years - have warned that much more tightening would lead to an unnecessarily severe recession.
Financial markets currently price in a 78% chance that the BoE will raise rates by half a percentage point to 3.5% on Dec. 15, and a 22% chance of a rise to 3.75%.
The central bank's immediate concern is British consumer price inflation, which hit 11.1% in October, the highest reading since 1981 and more than five times the BoE's 2% target, up from 4.2% a year earlier.
While much of the increase has been driven by higher energy prices following Russia's invasion of Ukraine, the BoE fears labour shortages and other bottlenecks caused by the COVID-19 pandemic and Brexit could make inflation slow to fall.
"To our minds, another 50 basis point increase looks likely," Investec economist Philip Shaw said. "The BoE has made it pretty clear that inflation is too high. It's concerned about the tightness of the labour market. And there are big risks to its projections."
Bailey has said Britons must accept reduced living standards because of the energy price shock, but the country is in the midst of a wave of industrial action as trade unions seek to limit the impact on their members.
Shaw views November's 75 basis point rate rise as a one-off, coming after market turmoil caused by Prime Minister Liz Truss's short-lived government and new assumptions of more generous government support for household energy bills.
But HSBC economist Liz Martins said another 75-basis-point rate rise was a possibility, if official figures on economic output, inflation and the labour market due next week were stronger than expected.
With a range of views on the MPC about how near BoE rates are to a peak, a first-ever four-way vote split was possible, she added.
"A generous spin would note the highly uncertain outlook and celebrate the lack of groupthink. More critical observers might say it adds to questions about the BoE's willingness and ability to act decisively to address the current inflation challenge," Martins wrote in a note to clients.
MPC member Catherine Mann has regularly voted for bigger rate rises than the majority this year, and remains concerned about the public and businesses' expectations for inflation over the medium term, which are well above the BoE's 2% target.
Last month, seven MPC members voted to raise rates to 3%, but Silvana Tenreyro voted for a quarter-point rise to 2.5% and Swati Dhingra for 2.75%.
Since then, Tenreyro has said rates should stay on hold so as not to push inflation well below target over the medium term, while Dhingra has said much more of an increase would cause an unnecessarily deep recession.
On Nov. 3, the BoE estimated Britain had entered a recession that would last until the end of next year and shrink output by 1.7% - a bigger drop than more recent forecasts, and one which partly reflects elevated market rate expectations at the time the forecasts were made.
Financial markets currently see BoE rates peaking at 4.75% by the middle of next year, while HSBC expects the BoE to stop at 3.75% in February and Investec predicts a peak of 4%.
(Reporting by David Milliken; Editing by Catherine Evans)