The Bank of England kept its benchmark interest rate unchanged at 3.75% on Thursday, a decision that aligned with broad market expectations. The central bank cautioned that rate hikes could become necessary if inflationary pressures intensify due to the Middle East conflict.

In a significant policy shift, the Bank abandoned its plan to sell long-dated UK government bonds and announced it would gradually reduce its £488 billion ($653 billion) debt portfolio by September 2034. Six policymakers, including Governor Andrew Bailey, voted to hold rates steady, while Catherine Mann, Megan Greene, and Huw Pill favored a 25-basis-point increase, maintaining the same division seen at the July meeting.

Bailey noted in prepared remarks that the global energy shock has so far had a limited impact on UK prices and wages. "But the longer this volatility persists, the greater the effect on inflation, and the more likely it becomes that we will need to raise bank rate," he added.

Traders trimmed their bets on further tightening, fully pricing in one rate increase by year-end with a 50% chance of another. UK government bonds rallied, with long-dated maturities leading gains as the 30-year yield dropped 5 basis points to 5.80%. The pound gave up earlier gains against the dollar, trading at 1.3374.

The escalation of the US-Iran conflict has complicated the Bank's decision-making. Surging oil and gas prices have pushed up fuel costs and created additional challenges for UK households facing the new year's energy price cap reset. The Bank maintained its core guidance from the September meeting to "act as necessary," adding that risks are "skewed to the upside" and more pronounced than in July. The minutes noted that price pressures are expected to increase in the coming months, with indirect effects not yet visible in the UK economy likely "delayed rather than diminished."

The Bank now projects inflation to reach twice its 2% target early next year and upgraded its third-quarter GDP growth forecast to 0.4%. The rate hold comes as other central banks tighten policy, with the Federal Reserve raising rates on Wednesday and the European Central Bank delivering its second 25-basis-point increase last week.

Where to begin assessing the decision

David Rees, global head of economics at Schroders Investment, framed the situation clearly: "Domestic inflation is under control, wage growth is decelerating, and unemployment near 5% indicates significant labor market weakness. Current economic conditions do not warrant higher interest rates." He added that "the bigger risk lies in fiscal policy."

Quantitative tightening overhaul: bond sales scrapped and balance sheet runoff slows

For bond investors, however, the Bank's quantitative tightening (QT) program for the coming year drew more attention than Thursday's rate decision. The Bank made major adjustments to its QT approach, scrapping plans to sell long-dated gilts and outlining a path to reduce its £488 billion debt portfolio by 2034.

Under the not-yet-finalized proposals, the Bank will retain £120 billion of gilts maturing in 2049 or later, matching them against future banknote issuance. Another £222 billion of gilts maturing by 2035 will be allowed to mature naturally, while the remaining £146 billion maturing between 2035 and 2049 will be sold at a pace of £20 billion annually, potentially through direct sales to the government via the Debt Management Office (DMO).

In a letter to Chancellor John Healey, Bailey stated the arrangement "preserves the independence of monetary policy" and would "maximize value for money across the life of the program by minimizing costs and risks."

All scheduled QT auctions will be paused until April next year to finalize the terms of sales to the DMO. This move aims to avoid competing with government bond issuance, thereby easing near-term pressure on gilt yields. However, the arrangement may slightly erode Healey's fiscal headroom.

Markets responded positively to the announcement, with long-dated gilts leading gains and the 30-year yield falling 5 basis points to 5.80%. The premium over swap rates, a measure sensitive to future bond supply, remained stable at 68 basis points.

Why the runoff pace matters

The new QT framework arrives amid intense criticism of how the program has been managed. Since the runoff began in 2022, quantitative tightening has accumulated £110 billion in losses borne by taxpayers, following a previous profit of £124 billion. Bank documents indicate an additional £100 billion in losses is expected.

Under the revised proposals, the portfolio would shrink at an average annual pace of £46 billion, including £20 billion in active sales. Markets had previously anticipated the Bank would slow the runoff to £50 billion annually over the next 12 months starting in October, down from £70 billion in the previous two years and £100 billion a year earlier.

The Treasury and the Bank have collaborated on this arrangement for nearly a year, though final terms remain unresolved. The Bank plans to sell gilts directly to the DMO, which could then cancel them and issue larger amounts of debt to better align with market demand. The final decision rests with the Treasury. The Bank confirmed that £120 billion of long-dated gilts will be retained as asset backing for cash in circulation, which represents a liability on its balance sheet.