The Bank of England has been forced to revise up its inflation forecasts as surging energy costs, labour shortages and chaos in the supply chain hold back Britain's recovery from Covid.
Inflation will rise above 4pc and stay there into the middle of next year, the Bank of England warned, meaning prices will be climbing more than twice as fast as its 2pc target.
It suggests that policymakers may raise interest rates faster than previously expected in a bid to tame rising prices. The Bank's Monetary Policy Committee (MPC) voted to keep stimulus unchanged at this month's meeting, but two members dissented and called for support to be reined in.
Economists rushed to upgrade their forecasts for a rate rise as a result, with markets now predicting that rates will climb from their current record low of 0.1pc to 0.25pc as soon as February. A further increase to 0.5pc is possible later in the year.
Allan Monks, of JP Morgan, said the announcement was more hawkish than expected.
Ruth Gregory, of Capital Economics, said: "The MPC is getting closer to raising rates. Our hunch right now is that the second half of the year seems more likely.
"But the clear risk is that it happens earlier."
Fears are growing over a cost of living crisis after gas and electricity prices shot up to record highs because of a shortage of the fossil fuel across Europe. British consumers are already facing an increase in the price cap on their energy bills next month, and it is all but certain to go up again sharply in April.
Meanwhile Brent crude has climbed from below $42 a barrel a year ago to more than $77 - hitting its highest level since October 2018 on Thursday night - pushing up prices at the pump for motorists.
The Bank has been split over the future path of inflation for months, with Governor Andrew Bailey repeatedly saying that the rise would likely only be temporary as the economy recovered from Covid.
Andrew Haldane, the former chief economist who left this summer, said in speeches that he feared a much more sustained increase in prices that risked harming the economy.
Mr Bailey has now admitted that he underestimated the impact of inflation. The Bank's forecasts previously said it would peak at 4pc, but Threadneedle Street now expects inflation "slightly above" this level. It also expects high prices to last for longer, until April instead of the end of this year.
However, policymakers are reluctant to act too quickly to rein in price rise as higher interest rates will have little effect on global problems but would risk undermining the recovery at home by raising the cost of borrowing.
In his letter to the Chancellor to explain why inflation was so far above target, at 3.2pc last month, Mr Bailey blamed energy prices, global commodities, shortages of key products such as microchips, and the rebound from prices held down a year ago by initiatives such as the Eat Out To Help Out meal subsidy scheme.
Mr Bailey told Rishi Sunak: “In the recent unprecedented circumstances, the economy has been subject to some of the largest shocks it has faced in centuries and economic activity has been exceptionally volatile."
The MPC said last month that it anticipates “some modest tightening of monetary policy" in the coming years. Mr Bailey added: “Some developments during the intervening period appear to have strengthened that case, although considerable uncertainties remain."
In part, the future of interest rates will depend on how wages respond to rising prices and how much companies choose to pass their higher costs on to consumers. Employer surveys indicate average pay rises of between 2pc and 3pc, above pre-Covid levels, while some workers in industries suffering from labour shortages are getting raises of between 10pc and 40pc.
Officials said they will wait to see whether the 1.6m workers still on furlough keep their jobs when the taxpayer-funded scheme ends next week, or become unemployed.
Sir Dave Ramsden, a deputy governor, joined Michael Saunders, an external member of the MPC, in voting to rein in quantitative easing early to reduce the risk posed by higher prices. They were outvoted by the MPC’s other seven members.
It means the Bank is on track to complete its asset purchases by the end of the year, by which point it will have built up a stock of £875bn of government bonds and £20bn of corporate bonds.
All nine policymakers voted to keep interest rates on hold on 0.1pc.
Kallum Pickering, an analyst at Berenberg Bank, said: “As growth momentum is slowing heading into autumn and amid rising risks, the bank of England will probably err on the side of caution for a while yet and wait until mid-year before lifting rates for the first time – perhaps with some strong interim guidance that a sustained normalisation of policy is on the way.”
Business growth slowed this month, according to the purchasing managers’ index, an influential survey from IHS Markit.
It fell to 54.1, its lowest in seven months. Any score above 50 indicates activity is growing, so this shows an expansion which remains robust but is no longer booming.
The survey also revealed companies are raising prices at the fastest pace since the monthly survey began in 2006.