Bank of England holds interest rates but warns of rises to come

Policymakers have warned that ‘strategy could change’ ahead of a difficult second half of the year

The Bank of England has chosen to keep interest rates at 3.75 per cent following better-than-expected UK inflation figures – though policymakers cautioned that “policy strategy could change” amid concerns over a challenging second half of the year for price stability.

The Monetary Policy Committee (MPC) maintained interest rates in a split 6-3 vote on Thursday, with economist Catherine Mann joining fellow external member Megan Greene and the Bank’s chief economist Huw Pill in backing a 25 basis point increase.

Officials stated that recent figures showing inflation had dropped to 2.6 per cent provided the Bank with some breathing space and enabled the MPC to maintain its current monetary policy stance.

Minutes from the MPC’s most recent meeting on setting interest rates indicated that those voting to hold rates steady believed “policy strategy could change” should inflation rise beyond projections due to renewed escalation of conflict across the Middle East.

The Bank projects inflation to hover around 3.2 per cent in early 2027 before returning to the target rate by year’s end, as reported by City AM.

Rate-setters cautioned that fresh trade disruption across the Gulf region could maintain elevated energy prices for an extended period, driving up inflation and prompting workers to negotiate higher wages.

Disruptions at oil and gas refineries across the globe, difficulties emerging among key suppliers due to heatwaves, and shortages in AI hardware could all compound the risks facing the UK’s inflation outlook, it was added.

The Bank’s decision to maintain interest rates is consistent with market expectations, though some City banks had anticipated only two members of the nine-person committee would back a rise.

Mann cited the breakdown in relations between the US and Iran as the key factor behind her decision, following a ceasefire agreement to the Iran war last month.

Governor Andrew Bailey, who described it as “too early” to conclude that the UK was heading towards a prolonged period of high inflation, said his focus remained on bringing consumer prices back to a stable growth rate of two per cent, in line with the Bank’s mandated target.

“Inflation has fallen faster than we’d expected, but the conflict in the Middle East continues to mean high and volatile energy prices,” Bailey said. “That will cause inflation to rise again later this year.

“However the conflict unfolds, our job is to make sure any increase in inflation is temporary.”

The Bank raised concerns over so-called “second-round effects”, whereby rising inflation and wage growth spiral out of control. Under a central scenario in which oil prices stabilise at around $70 per barrel, these effects may contribute only approximately 0.2 percentage points to consumer price index (CPI) inflation.

Employers are expected to finalise pay settlements with staff at the start of next year, around the point at which inflation is forecast to reach its peak.

In a separate, more “adverse” scenario, should oil prices climb back to $100 per barrel and retreat more gradually, inflation would peak at 4.5 per cent.

Officials indicated that the MPC would likely choose to raise interest rates under such circumstances. Back in April, one projection suggested there would be six interest rate hikes should oil prices remain around $130 per barrel.

However, rising yields on UK government bonds, reflecting an increase in market interest rates and driving up borrowing costs, had also helped to temper price growth in the UK. Bailey suggested that market curves “are weighing on any nascent inflation pressures”.

The energy price shock stemming from the conflict in the Middle East is likewise not anticipated to significantly weigh on growth prospects.

Economic growth this year is forecast at 1.1 per cent, even under a more adverse scenario in which oil prices spike once more, while unemployment is projected to peak at approximately 5.3 per cent under the central judgement.

Nevertheless, underlying growth in the UK economy is expected to decelerate later this year as businesses struggled to build momentum.

The forecasts took into consideration Prime Minister Andy Burnham’s early policy announcements regarding the removal of VAT from energy bills and capping bus fares at £2, though these measures were expected to have only a modest impact on curbing price growth.