(Bloomberg) -- Britain’s soaring wage inflation is likely to push the Bank of England to another sharp increase in interest rates this week.

Investors and economists expect the UK central bank to raise its key rate a half point to 4% on Thursday. That would mark the highest since 2008 and the quickest string of hikes in three decades.

The move will deliver more pain for households already struggling with the tightest cost-of-living squeeze in memory. More than 1 million public sector workers are set to walk off the job this week in protest that their wages aren’t keeping up with inflation, which rocketed to a 41-year high last year.

Policy makers led by Governor Andrew Bailey are concerned that wages are increasing at the strongest pace on record except for the period directly after the pandemic, adding to the risk of a wage-price spiral. Officials are preparing an annual pay survey and an assessment of the supply capacity of the economy, a measure of the UK’s growth “speed limit.”

The survey is expected to show that employers are planning further increases in pay settlements this year, while the supply review is likely to point to a tighter labor market than thought. Those factors are helping push up prices, underpinning the need for rate hikes — even though the economy is weakening.

What Bloomberg Economics Says ...

“A big GDP forecast upgrade and a slew of evidence showing sticky inflation will likely push the Bank of England to lift rates by 50 basis points at its first meeting of the year. We think the move will bring the central bank within touching distance of the terminal rate for this hiking cycle, though policymakers will probably refrain from giving a firm signal that borrowing costs are close to peaking.”

—Dan Hanson and Ana Andrade, Bloomberg Economics. Click for the PREVIEW. 

Despite forecasting a recession this year and a sharp fall in inflation from what they estimated in November, the BOE will have to squeeze the economy and drive up unemployment to prevent a wage-price spiral, said Michael Saunders, senior adviser to Oxford Economics and a policy maker at the central bank until last year. 

“The bank will have its annual survey of pay deals, which forms a key part of the decision,” Saunders said in an interview. “I would have thought it will be stronger than last year.” 

In 2022, the survey anticipated 4.8% pay rises, the highest in the 15-year history of the survey. The latest official figures show average earnings excluding bonuses were 6.4% higher in the three months through November than a year earlier. That’s the biggest increase since records began in 2001.

While the pace of those increases is well beyond the BOE’s comfort level, it’s still lagging inflation. The Consumer Prices Index rose 10.5% in December, down from a peak of 11.1% two months before but still more than five times the BOE’s 2% target rate.

Real wages adjusted for inflation are falling, delivering the sharpest squeeze on household spending power in memory. While BOE policy makers are increasingly concerned about the outlook for the economy, their main remit is to control inflation.

The nine-member Monetary Policy Committee split three ways in December, when the majority pushed through a half-point increase to 3.5%. Economists expect a similar split this month.

Alongside the vote, the central bank will publish its latest forecasts. They will show that this year’s recession will be shallower than previously projected and inflation will fall more rapidly, said Saunders.

Bailey indicated in an interview earlier this month that interest rates may not rise much further. Investors are betting on rates to peak no higher than 4.5% in the middle of the year and for the key rate to end the year about 4.25%.

For now, wages are one of the BOE’s key concerns. A survey by XpertHR showed planned settlements of 6% in January. 

“If the bank survey is anything like that it will carry a lot of weight,” Saunders said. More than a quarter of all pay deals are agreed in the first months of the year.

Rob Wood, UK economist at Bank of America, expects the review of the UK’s supply capacity to come to equally awkward conclusions. 

“We expect them to judge the labor market to be tighter than thought, which means they will need higher unemployment to reduce inflation,” Wood said.

The UK’s tight labor market reflects a shortfall of 300,000 workers compared with before the pandemic, with many dropping out for health or personal reasons. That leaves employers chasing a smaller pool of workers and having to bid up pay, and many workers especially in the public sector striking to push for big raises.

“These issues are here to stay,” said Victoria Clarke, UK chief economist at Santander Corporate & Investment Banking. “You’re still going to have fewer workers in the UK workforce than we had before.”

The central bank had expected the UK to be in recession already, but the economy has proved resilient so far, growing slightly in the fourth quarter. Falling energy prices and inflation have protected households from an even deeper collapse in living standards. 

The market path for interest rates is also lower than projected in November, lowering borrowing costs and supporting growth. Even so, the BOE is expected to forecast a recession that is about half as deep as the 2.5% contraction projected in November. 

“The forecasts will be less apocalyptic than before, but still bad,” Wood said.

--With assistance from Andrew Atkinson and Tom Rees.

©2023 Bloomberg L.P.