The Bank of England has cut interest rates for the first time since the start of the Covid pandemic, moving to ease the pressure on households after ratcheting up borrowing costs to combat the worst inflation shock in four decades.

In a finely balanced decision after holding borrowing costs at the highest level since the 2008 financial crisis for a year, 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%.

Exposing divisions within the central bank’s most senior ranks over the timing of a cut, the MPC was split by five votes to four, with the governor, Andrew Bailey, casting the deciding vote for the first reduction in borrowing costs since March 2020.

With headline inflation holding at the Bank’s 2% target for a second consecutive month in June, financial markets had expected a cut in rates, although City economists had predicted it would be a close call amid fears over stubbornly high inflation becoming entrenched. The pound fell against the US dollar and euro after interest rates were cut to 5%.

Bailey said inflationary pressures had “eased enough” to enable the first reduction in borrowing costs since the Bank stopped ramping up interest rates this time last year – the joint longest period that rates have been held after a hiking cycle since the turn of the millennium.

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 beginning to ease the pressure on households amid the cost of living crisis comes 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.

It will also be seized on by Rishi Sunak and Jeremy Hunt, the Conservative leader and shadow chancellor, as evidence they had been making progress on the economy when in government, albeit too late to benefit the former prime minister’s bet that falling inflation could strengthen his hand in a snap general election.

Hunt posted on X: “In government, we took difficult decisions that cut inflation from 11.1% to the Bank’s target 2% paving the way for lower rates. Our concern is that further substantive cuts may now take longer because of inflation-busting public sector pay rises rushed through by the chancellor ahead of the summer.”

However, Bailey disagreed, telling a press conference that public sector pay rises would have little impact on inflation. The governor said: “The Bank takes its lead on pay from the private sector, as that feeds directly into CPI [consumer prices index] inflation.”

Rachel Reeves, the chancellor, also disagreed with the suggestion that the Tories’ decisions in office may have led to the cut, saying: “Decisions around interest rates are of course decisions for the independent Bank of England, but I have been left with a £22bn black hole in the public finances.”

She added that while the reduction in rates was welcome news, “millions of families are still facing higher mortgage rates after the mini-budget”.

After 14 consecutive rate increases from a record low of 0.1% in December 2021, households and businesses across Britain had been under pressure from a sharp rise in mortgage repayments as the central bank responded to the highest rates of inflation since the early 1980s. Inflation peaked at 11.1% in October 2022 after the Russian invasion of Ukraine triggered a surge in energy prices.

Inflation has fallen back to the 2% government target in recent months, but prices remain significantly higher than three years ago and are still rising. Although the contribution from soaring energy costs has begun to fade, the Bank remains concerned over stubborn price rises in the service sector of the economy, and resilience in wage growth.

After narrowly voting to cut rates 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 said there were several potential paths for inflation that could materialise: either a continued reduction in inflationary pressures as high borrowing costs continued to 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 said it expected the economy would grow at slightly weaker rates of about 0.25% in the coming months, while warning that unemployment was on track to rise next year, justifying its first cut in borrowing costs since the onset of the Covid pandemic.

Signalling caution over its future decisions, the MPC warned that its policy stance would still 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.