The Bank of England has signaled that interest rates could rise later this year if the Middle East energy shock has a longer-lasting effect on the cost of living. The new outlook comes as interest rates were held at 3.75% on Thursday.
Monetary Policy Committee Decision
The Bank's Monetary Policy Committee (MPC) decided to hold borrowing costs steady but remains alert to the evolving situation in the Middle East. Members of the nine-person MPC indicated that future interest rate decisions could depend on how strong the second-round effects of higher global energy prices are, particularly in prices and wages.
Andrew Bailey, the Bank's governor, stated: "It would be a mistake to wait to see the second-round effects before acting, because it would be too late." The committee considered several potential scenarios, with a worst-case scenario potentially leading to multiple rate rises and an increased risk of recession.
Worst-Case Scenario
In the most extreme projection, energy prices rise sharply, with Brent crude oil reaching approximately 130 US dollars per barrel and remaining elevated for an extended period. This could cause inflation to peak at 6.2% and fail to return to the Bank's 2% target within the next four years. Mr. Bailey noted that he placed "some weight" on the most extreme predictions, which "would require a stronger monetary policy response." He added that the situation is highly unpredictable and that the Bank is monitoring events closely.
One policymaker, Huw Pill, voted to increase rates to 4% at the latest meeting, arguing that "higher energy prices represent an inflationary shock to the UK economy." The price of Brent crude rose as high as 126 dollars per barrel on Thursday, the highest in four years, following reports that US President Donald Trump was preparing for an escalation of the Iran war with further military action.
Impact on Mortgages and Economic Forecasts
Mortgage rates have risen sharply since the conflict escalated, although some lenders have been reducing rates in recent weeks. Following the Bank's decision, some economists now expect rates to rise this year. Experts at Pantheon Macroeconomics are pencilling in increases in June and September, while ING also stated that the Bank is "inching closer" to a hike in June.
The MPC's decision comes after the European Central Bank also kept its interest rate on hold but considered a hike given the risks to inflation. Policymakers noted that the Consumer Prices Index (CPI) inflation rate rose to a three-month high of 3.3% in March, driven by accelerating fuel prices. The central bank predicts that inflation is likely to slow slightly to 3.1% over the second quarter of this year, due to a lower energy price cap for households.
Inflation and Growth Projections
The April report, which uses three potential scenarios for the impact of the crisis, indicates that inflation is then set to increase even if the conflict is resolved and oil and gas prices cool. The most benign predictions see inflation peaking at 3.6% by the end of this year. The Bank stated that each scenario would also result in a slowdown in economic growth. It expects the economy to grow by 0.8% in 2026 and 1% in 2027 in its more benign projections, while this could be 0.7% this year and 0.8% next year if the situation worsens. In its previous forecast in February, the Bank pointed to 0.9% growth this year and 1.5% growth next year.
All Bank projections also include increased forecasts for unemployment. Previously, the Bank said unemployment would peak at 5.3% this year, slowing to 5.2% in 2027 and 5.1% in 2028. On Thursday, the Bank's most positive forecast indicated that unemployment would hit 5.5% for 2027, with this increasing to 5.6% in a more extreme scenario.
Chancellor's Response
Following the vote, Chancellor Rachel Reeves said: "The war in the Middle East is not our war, but it is one we have to respond to. Every choice I make will be about keeping costs down for families and businesses, without repeating the mistakes we've seen in the past that resulted in higher inflation and higher interest rates."
