UK Interest Rates Could Surge Above 4% If Energy Shock Persists, Warns Niesr
The National Institute of Economic and Social Research (Niesr) has issued a stark warning that UK interest rates could be pushed back above 4% if a persistent spike in oil and gas prices continues, driven by escalating conflict in the Middle East. The economic think tank highlighted that the Bank of England will have to contend with a significant "shock" to energy costs, which could create substantial challenges for Chancellor Rachel Reeves as financing costs increase.
Energy Price Surge Following Middle East Conflict
Oil and gas prices have experienced sharp increases since the intensification of the US-Israel war with Iran, leading to severe disruptions in the supply of these critical commodities. Iran has threatened to block the key shipping route, the Strait of Hormuz, in response to 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 the outbreak of fighting 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 earlier in the week, the underlying volatility remains a major concern for global markets.
Niesr's Analysis of Inflation and Economic Impact
Niesr published detailed analysis indicating that rising energy costs could significantly push up inflation in the UK. The research institute developed two scenarios to assess the potential outcomes. In the first scenario, oil prices rise by a further 30% and gas prices by 50%, but this spike is temporary, with energy prices normalising after three months.
Under this temporary shock, Consumer Prices Index (CPI) inflation for 2026 could increase by about 0.3 percentage points relative to previous forecasts from Niesr's February economic outlook. In such a case, the Bank of England and other central banks might look past the temporary energy shock, having little bearing on interest rates, though policymakers could still consider it in their decisions.
Persistent Energy Shock Scenario
In the second, more severe scenario, energy price rises persist for a full year before steadying. Niesr predicts this would push up CPI inflation by 0.7 percentage points in 2026 and by 0.5 percentage points in 2027. Additionally, it would weigh on UK gross domestic product (GDP), reducing it by 0.2 percentage points in 2026 and 0.3 percentage points in 2027.
Under this persistent shock scenario, Niesr stated that interest rates in the UK could increase by about 0.8 percentage points compared to its previous forecasts. This adjustment could force the Bank of England to push rates back up above 4%, a significant shift from earlier expectations.
Implications for Monetary Policy and Fiscal Outlook
In its February economic outlook, Niesr had anticipated that the Bank of England would cut interest rates twice this year, from the current 3.75% level, settling at about 3.25%. However, the new analysis suggests that the central bank might be compelled to reverse course and raise rates instead, highlighting the precarious nature of the current economic environment.
Ed Cornforth, an economist at Niesr, emphasised the material implications of the Middle East conflict on the economic outlook. He noted, "The Bank of England will have to contend with a shock to global energy prices, with the question of persistence hanging over their heads. This will cause problems for Rachel Reeves as financing costs increase, putting further pressure on an already precarious fiscal outlook."
The warning underscores the interconnectedness of geopolitical events, energy markets, and domestic economic policy, with potential ripple effects across inflation, interest rates, and overall economic stability in the UK.
