The National Institute of Economic and Social Research (Niesr) has issued a stark warning that UK interest rates could be driven back above 4% if ongoing conflict in the Middle East triggers a sustained surge in oil and gas prices. This economic think tank highlighted that the Bank of England must grapple with a significant "shock" to energy costs, which could create substantial challenges for Chancellor Rachel Reeves and the broader fiscal landscape.
Energy Price Volatility and Market Disruption
Oil and gas prices have experienced sharp increases since hostilities between the US-Israel alliance and Iran escalated, leading to severe disruptions in global commodity supplies. Iran has threatened to block the critical Strait of Hormuz shipping route in retaliation for military strikes, while Qatar announced a halt in liquefied natural gas production on Monday following attacks on its facilities.
The price of Brent crude oil has risen by approximately 15% since fighting erupted over the weekend, and analysts report that the European benchmark for natural gas has soared by about three-quarters. Although price rises showed signs of steadying on Wednesday after initial spikes, the underlying volatility remains a pressing concern.
Niesr's Economic Scenarios and Inflation Projections
Niesr's analysis outlines two potential scenarios based on escalating energy costs. In the first scenario, oil prices rise by an additional 30% and gas prices by 50%, but this spike is temporary, with prices normalising after three months. Under these conditions, Consumer Prices Index (CPI) inflation for 2026 could increase by about 0.3 percentage points compared to previous forecasts from Niesr's February economic outlook.
In this temporary shock scenario, the Bank of England and other central banks might overlook the short-term energy disruption, resulting in minimal impact on interest rates, though policymakers could still factor it into their decisions.
The second, more severe scenario involves energy price rises persisting for a full year before stabilising. Niesr predicts this would push CPI inflation up by 0.7 percentage points in 2026 and 0.5 percentage points in 2027, while also reducing UK gross domestic product (GDP) by 0.2 percentage points in 2026 and 0.3 percentage points in 2027.
Under this prolonged energy shock, Niesr estimates that UK interest rates could increase by about 0.8 percentage points relative to its earlier forecasts. Previously, in its February outlook, Niesr anticipated the Bank of England would cut interest rates twice this year, from the current 3.75% to around 3.25%. The new analysis suggests the Bank might instead be compelled to raise rates back above 4%.
Expert Insights and Market Reactions
Ed Cornforth, an economist at Niesr, emphasised the material implications of the Middle East conflict for the economic outlook. "The Bank of England will have to contend with a shock to global energy prices, with the question of persistence hanging over their heads," he stated. "This will cause problems for Rachel Reeves as financing costs increase, putting further pressure on an already precarious fiscal outlook."
Financial market expectations have shifted dramatically since the weekend, with traders sharply reducing their bets on a Bank of England interest rate cut at next week's meeting. James Smith, developed markets economist at ING, noted, "Investors have slashed expectations for a March rate cut from the Bank of England. Markets are pricing it with just a 20% probability, down from 80% pre-conflict."
Despite this, Smith maintains that UK interest rates "have further to fall," even if the next reduction is delayed. "We now expect the next Bank of England cut in April though March is still a distinct possibility if Middle Eastern tensions rapidly de-escalate," he explained. "With the jobs market still under pressure, further easing is still more likely than not."
The interplay between geopolitical tensions, energy market instability, and monetary policy decisions underscores the fragile state of the UK economy, with Niesr's warnings highlighting the potential for significant interest rate adjustments in response to persistent energy shocks.
