Shock as Bank lifts rates to 5.25%

Quarter-point rise piles misery on homeowners. Speculation that inflation has breached 3%

The Bank of England shocked the City and brought misery for homeowners and other borrowers yesterday by raising interest rates to 5.25 per cent - the highest for five years.

While a quarter-point rise from 5 per cent had been widely expected in February or March, almost no one thought the Bank's Monetary Policy Committee would act so quickly, prompting speculation that inflation may have breached the 3 per cent limit - the level above which the Governor Mervyn King must write a letter of explanation to Gordon Brown.

The financial bookmaker IG Index said it had not taken a single bet on a rise in rates, while only one of 50 economists polled by Reuters predicted an increase.

In a statement, the Bank said: "The margin of spare capacity in the economy appears limited, adding to domestic pricing pressures. CPI inflation was at 2.7 per cent in November. It is likely that inflation will rise further above the [2 per cent] target in the near term, but then fall back as energy and import price inflation abate."

Economists pointed to a trend of rising wage settlements and the continued strength of the housing market as causes for concern on the MPC.

The committee was given a preliminary forecast of the December inflation rate before making its decision. A spokesman for the Bank declined to comment on whether this showed inflation above 3 per cent, but the MPC has typically preferred to impose rate rises in the month of publication of its quarterly inflation report.

It has twice diverged from this policy, in 2000 and 2004, and on both occasions there were successive rises in the following month. A repeat of this would alarm banks, which are already facing soaring levels of bad debt and record insolvencies as increasingly hard-pressed consumers struggle to meet repayments on Britain's £1.3 trillion of consumer debt.

Share prices on the London Stock Exchange, however, finished strongly ahead after an initial fall when the rate rise was announced at midday. The FTSE 100 closed up 69.4 points at 6230.1. IG trader Tim Hughes said: "What has caught people by surprise is that the rise has come early. The rise itself was not unexpected at all."

The pound also rose, finishing up 0.64 cents against the dollar at $1.9415. Euronext Liffe, the London futures exchange, reported record volumes in sterling futures contracts yesterday.

The UK interest rate now matches that of the US. The European Central Bank lifted rates to 3.5 per cent in December and Jean-Claude Trichet, its president, hinted at a further rise in March after leaving it unchanged yesterday.

Reaction to the rise was mixed. David Owen, senior economist at Dresdner Kleinwort, said: "The worry for the Bank is what effect this will have on correcting the housing market."

Karen Ward, economist at HSBC, said: "There are a number of reasons the Bank may have felt it could not wait until the February meeting. First, the major private sector pay round is this month. If the Bank felt on the back of strong demand, it needed to send another message to wage setters, February could be too late. Second, the BoE will have received December's CPI release in advance. This was expected to be dangerously close to the 3.1 per cent reading."

The TUC accused the bank of "panic". The Liberal Democrat Treasury spokesman, Vince Cable, said it would "squeeze" hard-pressed families, while the manufacturers association, the EEF, said it was "disappointed".