By David Milliken and Andy Bruce
LONDON (Reuters) - The Bank of England raised interest rates by the most since 1989 on Thursday but warned investors that the risk of Britain's longest recession in at least a century means borrowing costs are likely to rise less than they expect.
The BoE increased Bank Rate to 3% from 2.25% and warned that the British economy might not grow for another two years - the longest slump in records dating back to the 1920s - if rates were to go up by as much as markets have recently bet.
"We can't make promises about future interest rates but based on where we stand today, we think Bank Rate will have to go up by less than currently priced in financial markets," Governor Andrew Bailey said, in an unusually blunt message.
Sterling extended earlier heavy losses and was down almost 2% on the day against the dollar, touching its lowest since mid October when Britain was recovering from a political crisis triggered by former prime minister Liz Truss' tax-cutting plans.
On Wednesday, the Federal Reserve also hiked rates by 75 basis points but signalled U.S. borrowing costs were likely to rise more than anticipated to crush inflation.
That contrasted with the British central bank's message on Thursday.
The BoE said it now expects inflation will hit a 40-year high of around 11% during the current quarter, more than five times its 2% target. But it also thinks the economy has entered a recession that could mean it contracts in both 2023 and 2024 and shrinks by 2.9% in total.
Unemployment would rise steadily to 6.4% by late 2025, nearly doubling from a current 3.5%, its lowest rate since 1974.
However, these forecasts reflected market expectations in late October that Bank Rate would peak at 5.2%, a level the BoE said on Thursday it did not expect to reach.
The BoE said that if it did not raise rates further, the recession would be shorter with a quarter of positive growth in the middle of it and a cumulative 1.7% loss of output.
Britain's economy shrank by 6.3% during the global financial crisis in 2008-9.
Thursday's rise in borrowing costs - the biggest in 33 years apart from a failed attempt to support the pound on Black Wednesday in 1992 - was in line with economists' expectations in a Reuters poll, but the nine policymakers were not unanimous.
Silvana Tenreyro and Swati Dhingra voted for smaller increases of a quarter and half a percentage point respectively, highlighting headwinds from recession.
Markets were expecting Bank Rate to peak at around 4.7%, little changed by the BoE's announcement.