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LONDON — The Bank of England voted to raise its base rate to 2.25% from 1.75% on Thursday, lower than the 0.75 percentage point increase that had been expected by many traders.

Inflation in the U.K. dipped slightly in August but at 9.9% year-on-year remained well above the bank’s 2% target. Energy and food have seen the biggest price rises, but core inflation, which strips out those components, is still at 6.3% on an annual basis. 

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The BOE now expects inflation to peak at just under 11% in October, down from a previous forecast of 13%.

The smaller-than-expected hike came as the bank said it believed the U.K. economy was already in a recession, as it forecast GDP would contract by 0.1% in the third quarter, down from a previous forecast of 0.4% growth. It would follow a 0.1% decline in the second quarter.

Numerous analysts, along with business association the British Chambers of Commerce, have previously said they expect the U.K. to enter a recession before the end of the year. As well as energy price shocks, it faces trade bottlenecks due to Covid-19 and Brexit, declining consumer sentiment, and falling retail sales.

The BOE dropped its key rate, known as the bank rate, down to 0.1% in March 2020 in an attempt to prop up growth and spending at the onset of the coronavirus pandemic. However, as inflation began to rise sharply late last year, it was among the first major central banks to kick off a hiking cycle at its December meeting. 

This is its seventh consecutive rise and takes U.K. interest rates to a level last seen in 2008.

In a release explaining its decision, the bank noted volatility in wholesale gas prices but said announcements of government caps on energy bills would limit further increases in consumer price index inflation. However, it said there had been more signs since August of “continuing strength in domestically generated inflation.”

It added: “The labour market is tight and domestic cost and price pressures remain elevated. While the [energy bill subsidy] reduces inflation in the near term, it also means that household spending is likely to be less weak than projected in the August Report over the first two years of the forecast period.”

Five members of its Monetary Policy Committee voted for the 0.5 percentage point rise, while three voted for a higher 0.75 percentage point increase that had been expected by many. One member voted for a 0.25 percentage point hike.

The bank said it was not on a “pre-set path” and would continue to assess data to decide the scale, pace and timing of future changes in the bank rate. The committee also voted to begin the sale of U.K. government bonds held in its asset purchase facility shortly after the meeting and noted a “sharp increase in government bond yields globally.”

The bank’s decision comes against a backdrop of an increasingly weak British pound, recession forecasts, the European energy crisis and a program of new economic policies set to be introduced by new Prime Minister Liz Truss. 

Sterling hit fresh multidecade lows against the dollar this week, trading below $1.14 through Wednesday and dipping below $1.13 early Thursday. It has fallen precipitously against the greenback this year and was last at this level in 1985. It was up 0.2% after the BOE decision with the 0.5 percentage point rise fully priced in.

The devaluation of the pound has been caused by a combination of strength in the dollar — as traders flock to the perceived safe haven investment amid global market volatility and as the U.S. Federal Reserve hikes its own interest rates — and grim forecasts for the U.K. economy. 

Meanwhile, the country’s newly formed government has set out numerous significant economic policy proposals this month ahead of a “fiscal event,” dubbed a mini-budget, when they will be officially announced on Friday.

This is expected to include a reversal of the recent rise in the National Insurance tax, cuts in levies for businesses and homebuyers, and a plan for “investment zones” with low taxes.

Truss has repeatedly stressed a commitment to lowering taxes in a bid to boost economic growth.

However, the energy crisis has also meant the government has announced a huge spending package to curb soaring bills for households and businesses.

Data published Wednesday showed the U.K. government borrowed £11.8 billion ($13.3 billion) last month, nearly twice as much as forecast and £6.5 billion more than the same month in 2019, due to a rise in government spending.

David Bharier, head of research at business group the British Chambers of Commerce, said the bank faced a “tricky balancing act” in using the blunt instrument of rate rises to control inflation.

“The bank’s decision to raise rates will increase the risk for individuals and organisations exposed to debt burdens and rising mortgage costs – dampening consumer confidence,” he said in a note.

“Recent energy price cap announcements will have provided some comfort to businesses and households alike and should place downward pressure on the rate of inflation.”

“The bank, looking to dampen consumer demand, and government, looking to increase growth, could now be pulling in opposite directions,” he added, saying the coming economic statement from the finance minister Friday was a “critical moment.”

Samuel Tombs, chief U.K. economist at Pantheon Macroeconomics, said the bank was hiking at a “sensible pace” given the lower inflation outlook and emerging slack in the economy.

Tombs forecast a 50 basis point increase at the bank’s November meeting, with risks titled toward a 75 basis point hike given the hawkishness of three committee members. He said this was likely to be followed by a 25 basis point rise in December, taking the bank rate to 3% at the end of the year, with no further hikes next year.

The U.K. is not alone in raising interest rates to combat inflation. The European Central Bank raised rates by 75 basis points earlier this month, while Switzerland’s central bank hiked by 75 basis points Thursday morning. The U.S. Federal Reserve increased its benchmark rate range by the same amount Wednesday.

Ukraine’s counteroffensive, which has seen vast swathes of Russian-occupied territory get recaptured, could be compounding Russia’s economic troubles, as international sanctions continue to hammer its fortunes.

Ukraine’s military has had stunning success in recent weeks, recapturing Russian-occupied territory in the northeast and south of the country. Now, Kyiv is hoping to liberate the Luhansk in the eastern Donbas region, a key area where one of two pro-Russian self-proclaimed “republics” is located.

Holger Schmieding, chief economist at Berenberg, said the recent Ukrainian military gains could hit Russia’s economy hard.

“Even more so than before, the Russian economy looks set to descend into a gradually deepening recession,” Schmieding said in a note last week. 

“The mounting costs of a war that is not going well for [Russian President Vladimir] Putin, the costs of suppressing domestic dissent and the slow but pernicious impact of sanctions will likely bring down the Russian economy faster than the Soviet Union crumbled some 30 years ago.”

He highlighted that Russia’s main bargaining chip when it comes to the international sanctions imposed by the West – its influence over the energy market, particularly in Europe – was also waning.

“Although Putin closed the Nord Stream 1 pipeline on 31 August, the EU continues to fill its gas storage facilities at a slightly slower but still satisfactory pace,” he noted, adding that even Germany — which was particularly exposed to Russian supplies — could even get close to its 95% storage target ahead of winter.

Europe’s rapid shift away from Russian energy is particularly painful for the Kremlin: the energy sector represents around a third of Russian GDP, half of all fiscal revenues and 60% of exports, according to the Economist Intelligence Unit.

Energy revenues fell to their lowest level in over a year in August, and that was before Moscow cut off gas flows to Europe in the hope of strong-arming European leaders into lifting the sanctions. The Kremlin has since being forced to sell oil to Asia at considerable discounts.

The decline in energy exports means the country’s budget surplus has been heavily depleted.

“Russia knows that it has no leverage left in its energy war against Europe. Within two or three years, the EU will have gotten rid of its dependency on Russian gas,” the EIU’s Global Forecasting Director Agathe Demarais told CNBC. 

This is a key reason why Russia has opted to cut off gas flows to Europe now, she suggested, with the Kremlin aware that this threat could carry far less weight in a few years’ time.

The EIU is projecting a Russian GDP contraction of 6.2% this year and 4.1% next year, which Demarais said was “huge, by both historical and international standards.”

“Russia did not experience a recession when it was first placed under Western sanctions in 2014. Iran, which was entirely cut off from Swift in 2012 (something that has not happened to Russia yet), experienced a recession of only around 4% in that year,” she said.

Statistics are scarce on the true state of the Russian economy, with the Kremlin keeping its cards relatively close to its chest. However, Bloomberg reported earlier this month, citing an internal document, that Russian officials are fearing a much deeper and more persistent economic downturn than their public assertions suggest.

Putin has repeatedly claimed that his country’s economy is coping with Western sanctions, while Russia’s First Deputy Prime Minister Andrei Belousov said last month that inflation will come in around 12-13% in 2022, far below the gloomiest projections offered by global economists earlier in the year.

Russian GDP contracted by 4% in the second quarter of the year, according to state statistics service Rosstat, and Russia upped its economic forecasts earlier this month, now projecting a contraction of 2.9% 2022 and 0.9% in 2023, before returning to 2.6% growth in 2024.

However, Demarais argued that all visible data “point to a collapse in domestic consumption, double-digit inflation and sinking investment,” with the withdrawal of 1,000 Western firms also likely to have implications for “employment and access to innovation.”

“Yet the real impact of sanctions on Russia will be felt mostly in the long term. In particular, sanctions will restrict Russia’s ability to explore and develop new energy fields, especially in the Arctic region,” she said. 

“Because of Western penalties, financing the development of these fields will become almost impossible. In addition, U.S. sanctions will make the export of the required technology to Russia impossible.”

In her State of the Union address last week, European Commission President Ursula von der Leyen lauded the impact of EU sanctions, claiming that Russia’s financial sector is “on life support.”

“We have cut off three quarters of Russia’s banking sector from international markets. Nearly one thousand international companies have left the country,” she said.

“The production of cars fell by three-quarters compared to last year. Aeroflot is grounding planes because there are no more spare parts. The Russian military is taking chips from dishwashers and refrigerators to fix their military hardware, because they ran out of semiconductors. Russia’s industry is in tatters.”

She added that the Kremlin had “put Russia’s economy on that path to oblivion” and vowed that sanctions were “here to stay.”

“This is the time for us to show resolve, not appeasement,” von der Leyen said.

As the Kremlin scrambles to strengthen security ties, having been shunned by the West, a top Russian official stated on a visit to Beijing last week that Moscow sees deepening strategic ties with China as a key policy aim. Putin also met Chinese President Xi Jinping in Uzbekistan last week as the two countries touted a “no limits” relationship.

However, several commentators have noted that as Russia’s bargaining power on the world stage wanes, China will hold most of the cards as the two superpowers attempt to cement further cooperation.

“In the long term, China will be the sole economic alternative for Russia to turn to, but this process will be tricky, too, as China will remain wary of becoming overdependent on Russian commodities,” the EIU’s Demarais added.