BoE signals potential hikes as Iran war fuels inflation concerns

The Bank of England kept interest rates unchanged on Thursday, while warning that a prolonged energy shock linked to the Iran war could force a sharper tightening of monetary policy.

The central bank’s Monetary Policy Committee (MPC) voted 8-1 to hold the benchmark Bank Rate at 3.75%.

Chief Economist Huw Pill was the sole dissenter, voting for an immediate increase to 4.0%.

The decision comes a day after the Federal Reserve kept rates on hold, and ahead of an expected pause by the European Central Bank.

Inflation risks balanced by weakening labour market

The MPC said it would continue to monitor developments in the Middle East closely.

Policymakers highlighted the risk of “material second-round effects” from rising energy prices, including higher wage demands and businesses passing on costs to consumers.

At the same time, the central bank noted signs of a weakening labour market and said higher borrowing costs in financial markets could help contain inflationary pressures.

“The Committee stands ready to act as necessary to ensure that CPI inflation remains on track to meet the 2% target in the medium term,” the MPC said, as cited in a Reuters report.

BoE drops central forecast, outlines scenarios

Facing heightened uncertainty, the Bank of England abandoned its usual central forecast and instead outlined three potential scenarios based on energy prices and second-round effects.

Under the most severe Scenario C, inflation could peak at 6.2% and remain above the 2% target for three years.

This scenario assumes persistently high energy prices and stronger inflationary spillovers.

Global oil prices rose above $122 a barrel on Thursday, the highest since March 2022, amid concerns over a prolonged blockade of the Strait of Hormuz.

If such conditions materialise, the BoE said it would be “likely to warrant a forceful tightening in monetary policy.”

In contrast, Scenarios A and B suggest a less aggressive policy response, with rising market-based borrowing costs already helping to offset inflation.

Policymakers divided on next steps

BoE Governor Andrew Bailey said he placed the most weight on Scenario B, “albeit with slightly reduced second-round effects,” while also assigning “some weight” to Scenario C.

Around half of the MPC members who supported holding rates also leaned towards Scenario B.

The central bank noted differing views within the committee.

Some members “might prefer to act early” to prevent inflation from becoming entrenched, while others favour waiting for clearer evidence.

Before Thursday’s decision, investors had priced in nearly three quarter-point rate increases for the year.

Growth concerns and fiscal pressures persist

Beyond inflation, the BoE flagged risks to economic growth.

Britain is seen as particularly vulnerable to rising energy costs due to its reliance on natural gas.

Recent data showed firms facing higher input costs and raising price expectations at a record pace.

At the same time, political uncertainty is adding to investor concerns.

Prime Minister Keir Starmer is facing challenges in maintaining control, raising questions about fiscal policy direction.

British government bond yields are currently the highest among Group of Seven economies, underscoring market concerns over inflation and fiscal risks.

Bailey and other senior officials are scheduled to hold a news conference later in the day.