By Harry Robertson
LONDON (Reuters) -Sterling dropped sharply on Thursday after the Bank of England said borrowing costs were likely to go up less than markets expect and warned that the economy was heading for a protracted recession even as it raised rates by the most in three decades.
In unusually forthright language, the BoE pushed back against traders' expectations that interest rates were likely to rise to around 5% next year. This contrasts with the U.S. Federal Reserve, which hiked aggressively once again on Wednesday and said rates were not yet close to their peak.
The pound was already down around 1.2% against the dollar on Thursday after the Fed meeting but dropped sharply after the BoE decision and statement, at one point falling more than 2% to a low of $1.1157.
It was last down 1.67% at $1.12, putting it on track for its biggest daily fall since the British government's tax-cutting mini-budget on Sept. 23.
The BoE raised Bank Rate by 75 basis points (bps) in an effort to tame double-digit inflation, taking it to a 14-year high of 3%. It was the biggest rate hike since 1989, apart from a failed attempt to boost sterling on Black Wednesday in 1992.
In a highly gloomy message, the BoE said Britain - which is grappling with a sharp rise in energy and mortgage costs - has probably tipped into a recession. It said the downturn could cause the economy to shrink in both 2023 and 2024.
The euro rallied 1.15% against the pound to 87.16 pence.
Analysts said sterling was reacting to the much less aggressive tone of the BoE compared to the Fed, as well as the dire economic outlook.
"The story is definitely moving from central banks pivoting to central bank policy divergence," said Michael Quinn, senior trader at Monex Europe. "The fundamentals in the U.S. are certainly more robust and healthy than in Europe… It's a pretty grim scenario for sterling at the moment."
The Fed raised interest rates by 75 bps for the fourth meeting in a row on Wednesday. It took the target range to 3.75% to 4%, from just 0% to 0.25% in March.
Fed Chair Jerome Powell signalled that the central bank may step down the rate at which it raises borrowing costs. But he also said the peak in rates was likely to end up higher than traders expect.
In contrast, BoE Governor Andrew Bailey said on Thursday: "We think Bank Rate will have to go up by less than currently priced in financial markets."
The dollar index rose 0.56% to a two-week high of 112.77 on Thursday as investors reacted to the Fed's move.
Higher rates - or the expectation of them - traditionally boost a country's currency by making investments there look more attractive.
"While some central banks are saying they don't know how high rates will go, the BoE is saying the peak is lower than what the market is pricing," said Jan von Gerich, chief economist at Nordea. He said sterling was likely to face further pressure against the dollar.
(Reporting by Harry Robertson,Editing by Kim Coghill, David Evans and Emelia Sithole-Matarise)