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The Bank of England has kept interest rates on hold and signalled it could be forced to increase borrowing costs within the coming months as the US-Israel war on Iran threatens to drive inflation in the UK above 3%.
As households brace for a surge in living costs, the Bank’s rate-setting monetary policy committee (MPC) voted unanimously to keep its base rate at the current level of 3.75% amid growing concern over the surge in energy prices triggered by the conflict.
It warned that the “new shock” to the economy would lead to higher than previously expected inflation in the short term, putting further pressure on household finances already battered by a cost of living crisis.
Andrew Bailey, the Bank’s governor, said: “War in the Middle East has pushed up global energy prices. You can already see that at the petrol pump and if it lasts it will feed into higher household energy bills later in the year.
“The best way to tackle this is at the source by reopening energy supply lines. We have held interest rates at 3.75% as we assess how events unfold. Whatever happens, our job is to make sure inflation gets back to its 2% target.”
Against an increasingly volatile backdrop in global markets, the Bank said it expected the Iran conflict would keep inflation in the UK above 3% this year based on current oil and gas prices. Oil prices jumped again on Thursday, with a barrel of Brent crude hitting $114, while European gas prices surged by a further 17%.
Financial markets had been pricing in an almost 100% chance of a hold decision, reversing expectations before the outbreak of the war for a cut in rates amid cooling inflationary pressures, a slowdown in the jobs market and weakness in economic activity.
Headline inflation had been expected to fall from 3% now to about 2% from April, partly owing to measures announced by Rachel Reeves in her autumn budget to cut household energy bills. But the Bank warned the rate would probably rise to about 3.5% in March and stick at more than a percentage point above its 2% target throughout 2026.
With consumers already feeling the pinch, Threadneedle Street said the direct impact of rising energy prices would add about 0.75 percentage points to inflation this autumn, while businesses passing on higher costs could add a further 0.25 percentage points.
Some members of the MPC signalled they would have voted for a reduction in borrowing costs before the outbreak of the war, including Sarah Breeden and Dave Ramsden, two of the Bank’s deputy governors.
However, others warned borrowing costs may need to rise in response to a sustained inflation shock, including the economist Swati Dhingra, who had previously been one of the most consistent advocates for rate cuts.
Economists have said a prolonged conflict and higher energy prices could have serious consequences for living standards worldwide.
UK inflation reached 11.1% in late 2022, the highest level in four decades, after the energy crisis triggered by Russia’s invasion of Ukraine.
Megan Greene, an external member of the committee, said in the minutes of the MPC decision that households and businesses were more likely to be more sensitive to a new inflation shock because inflation had already been above the 2% target for the best part of five years.
However, in contrast to the energy price shock in 2022 – when Russia’s war in Ukraine coincided with a surge in demand and global supply bottlenecks after the easing of Covid pandemic restrictions – the backdrop for the economy was weaker.
Bailey said in the minutes of the MPC meeting: “The recent experience of high inflation may … make households and businesses more sensitive to a new inflationary shock. At the same time, the starting point for this shock is a real economy with limited pricing power.”
