The Bank of England has decided to maintain interest rates at 3.75%, but it cautioned that the United Kingdom must prepare for potential rate increases later this year as "higher inflation is unavoidable" due to the ongoing war in the Middle East. The Bank's rate-setting Monetary Policy Committee (MPC) voted 8-1 to keep borrowing costs unchanged on Thursday.
Governor's Statement on Economic Impact
Andrew Bailey, the Governor of the Bank of England, stated: "The war in the Middle East is causing inflation to rise again this year." He added that policymakers are closely monitoring the global situation and its repercussions on the UK economy. Bailey described the decision to hold rates at 3.75% as a "reasonable place given the situation of the economy and the unpredictability of events in the Middle East."
Inflation Outlook and Recent Data
The MPC's primary objective is to maintain UK inflation at a target of 2%. Since mid-2024, the committee has reduced interest rates six times, and further cuts were anticipated this year before the US-Israeli conflict with Iran began. However, the Bank now asserts that the Middle East conflict has drastically altered the inflation outlook compared to three months ago, when inflation was expected to drop to 2% by mid-year. According to the latest Office for National Statistics (ONS) figures, the UK inflation rate rose to 3.3% in March, up from 3% in February.
Energy Prices and Economic Effects
The Bank noted that the sharp increase in energy prices is already impacting the UK through higher fuel costs. This is likely to push inflation further upward as these higher energy prices permeate the economy. Nevertheless, policymakers believe that second-round effects may be restrained. The Bank highlighted that labour demand in the UK is subdued, and unemployment has been rising since 2024, which limits workers' ability to negotiate higher wages. Similarly, companies' capacity to raise prices is constrained by weak consumer demand amid shaky confidence.
"Relative to the previous energy shock of 2022 after the start of the Russian-Ukrainian war, current events are occurring from a starting point of lower inflation, weaker demand, a looser labour market, and a restrictive monetary policy," the Bank explained.
Dissenting Vote and Scenarios
The sole dissenting voice on the MPC was Huw Pill, the Bank's Chief Economist, who voted to raise rates to 4%. Pill expressed concerns about second-round effects of higher prices and wages being "skewed to the upside," warning they could persistently elevate UK inflation beyond the near term.
The Bank outlined three scenarios for the UK economy based on different impacts of the Iran war. In all cases, inflation is expected to rise, and unemployment will increase to at least 5.5%.
- Scenario A (Benevolent): Oil peaks at $108 per barrel this year, falls below $80 by early 2027, and reaches $72 by end of 2028. Inflation is 3.3% in 2026, 2.6% in 2027, and 1.5% in 2028. Unemployment rises to 5.5% in 2027 and drops to 5.4% in 2028.
- Scenario B (Moderate): Oil peaks at $108 but remains higher for longer. Inflation is 3.3% in 2026, 3% in 2027, and 2% in 2028. Unemployment follows the same path as Scenario A.
- Scenario C (Worst-case): Oil peaks at $130 per barrel and stays elevated. Inflation peaks at 6.2% in early 2027, with interest rates rising to 5.25% before falling to 2.9% by 2028. Unemployment rises to 5.6%.
Earlier on Thursday, Brent crude hit a four-year high of $126 per barrel but later dropped to $115.50.
Government and Economic Context
Bailey described the decision as "a deliberately active hold," clarifying that it is not a signal that interest rates are about to rise, although the Bank's modelling suggests rates may need to increase under Scenarios B and C. The decision to keep rates unchanged provides relief to the Labour government ahead of important local elections next week.
Chancellor Rachel Reeves had previously announced anti-inflation measures in her late November budget, including cuts to utility bills and a rail-fare freeze effective in April, which should temper inflation for the current month.
Before the energy price shock, UK economic activity showed momentum. In the three months to February, GDP grew by 0.5%, and the unemployment rate fell from 5.2% to 4.9%.
