The Bank of England has cut interest rates for the first time in four and a half years, easing pressure on households after it raised borrowing costs to the highest level since the 2008 financial crisis in response to soaring inflation.

In a finely balanced decision after the worst inflation shock in decades, the Bank’s monetary policy committee (MPC) voted by a narrow majority to cut its base rate by a quarter of a percentage point to 5%.

With inflation holding at the Bank’s 2% target for a second consecutive month in June, financial markets had expected rates would be cut, although City economists predicted it would be a close call. The pound fell against the US dollar and euro after the decision.

The Bank of England governor, Andrew Bailey, said inflationary pressures had “eased enough” to enable the first cut since the Bank stopped ramping up borrowing costs this time last year.

However, Bailey said savers and borrowers should not expect large reductions over the coming months, amid concerns about lingering risks to the economy. “We need to make sure inflation stays low, and be careful not to cut interest rates too quickly or by too much,” he said.

“Ensuring low and stable inflation is the best thing we can do to support economic growth and the prosperity of the country.”

Threadneedle Street’s decision to start easing pressure on households came after a sharp fall in inflation this year and will be a welcome step for the new Labour government as Keir Starmer aims to revive flatlining living standards and a stagnating economy.

Rishi Sunak and Jeremy Hunt, the Conservative leader and shadow chancellor, claimed the decision showed they had been making progress on the economy when in government, albeit too late to benefit the former prime minister’s gamble that falling inflation could strengthen his hand in a snap general election.

In a political battle after the Bank’s announcement, the chancellor, Rachel Reeves, claimed millions of families were still facing higher mortgage rates after Liz Truss’s mini-budget. However, Hunt argued that Labour’s plan for above-inflation public sector pay increases risked keeping interest rates higher for longer.

Bailey disagreed, telling a press conference that public sector pay rises would have little impact. The governor said: “The proverbial back of the envelope suggests an increment in the inflation space which is very small.”

Households and businesses across Britain have been under pressure from a sharp rise in mortgage repayments after the Bank put up rates 14 times in a row from a record low of 0.1% in December 2021, in response to the highest rates of inflation since the early 1980s. Inflation peaked at 11.1% in October 2022, amid a surge in energy prices triggered by the Russian invasion of Ukraine.

Inflation fell back to the 2% government target in May, but prices remain significantly higher than three years ago and are still rising. The Bank remains concerned over stubborn price increases in the service sector of the economy and resilience in wage growth.

After its vote, the MPC warned that headline inflation was on track to rise to about 2.75% within months, overshooting its target. However, the Bank forecasts inflation will fall back to about 1.7% in two years’ time, before dropping to 1.5% in 2027.

The MPC was split by five votes to four, exposing divisions within the central bank’s most senior ranks, with Bailey casting the deciding vote for a quarter-point reduction.

The cut was opposed by the Bank’s chief economist, Huw Pill, alongside the external MPC members Jonathan Haskel, Megan Greene and Catherine Mann, who warned that domestic inflationary pressures remained. Bailey was joined in voting for a cut by the deputy governors Clare Lombardelli, Sarah Breeden and Dave Ramsden, alongside the external member Swati Dhingra.

The MPC said there were several potential paths for inflation that could materialise: either a continued reduction in inflationary pressures as high borrowing costs weigh on the economy and the jobs market, or a scenario with higher inflation for longer if economic activity remained stronger than anticipated.

Britain’s economy has grown at a faster rate than anticipated in recent months, exiting recession in the first quarter with growth of 0.7% – double the levels recorded in France and Germany. While the economy flatlined in April, it grew at a faster rate than anticipated in May.

The Bank upgraded its growth forecasts for this year to 1.25%, more than double the previous estimate of 0.5%. However, it warned that quarterly growth would probably be weaker than in recent months, while unemployment was on track to rise.

Signalling caution over its future decisions, the MPC said its policy stance would remain at “restrictive” levels that would bear down on economic activity even after the reduction in interest rates. “Monetary policy will need to continue to remain restrictive for sufficiently long until the risks to inflation returning sustainably to the 2% target in the medium term have dissipated further,” it said.