Inflation spike from Iran war could derail rate cuts, warns Bank of England

The Bank of England warned it may have to take a tougher line on interest rates as the spike in energy prices caused by the U.S.-Israeli war on Iran pushes inflation higher.

“Monetary policy cannot reverse this shock” to world energy supply, Governor Andrew Bailey said in a statement on Thursday, after the Monetary Policy Committee voted unanimously to leave the Bank rate unchanged at 3.75 percent.

“Monetary policy must, however, respond to the risk of a more persistent effect on U.K. consumer price inflation,” Bailey added.

The Bank had only last month declared victory over inflation, which has been above its 2 percent target for over four years. However, its latest analysis suggests headline inflation will rebound back above 3 percent in the next three months and could add as much as 0.75 percentage points to the consumer price index over the summer, as higher fuel bills percolate through the economy.

“The MPC is alert to the increased risk of domestic inflationary pressures through second-round effects in wage and price-setting, the risk of which will be greater the longer higher energy prices persist,” the Bank stressed. However, it also acknowledged that the energy price spike is likely to hurt economic growth, and that it is “assessing the implications for inflation of the weakening in economic activity that is likely to result from higher energy costs.”

Until the U.S. and Israel attacked Iran, most analysts had predicted that a slowing economy and growing prospects of easing inflation would allow the MPC to cut rates at Thursday’s meeting.

However, the invasion and the ensuing turmoil in world commodity markets have turned the situation on its head, by closing a vital chokepoint at the mouth of the Persian Gulf, through which irreplaceable volumes of oil, gas and fertilizer pass every day.

As a result, the Bank warned that there is now a real threat of higher energy prices causing a broader rise in prices across the economy. Food prices face a similar risk.

Already out of date?

The situation is changing so fast that the Bank’s latest forecasts could already be out of date. The Bank said they were based on the situation as of March 16, when Brent oil futures were only at $100 a barrel. But a succession of strikes on key energy installations around the Persian Gulf since then has already pushed prices up by another 12 percent.

“The news flow around the war in Iran looks more worrying for global markets with each passing day,” Deutsche Bank strategist Jim Reid said in a note on Thursday.

Analysts argued ahead of the meeting that the Bank would prefer to err on the side of keeping policy tight in the face of the new risks, given lingering concerns about its credibility due to its slow response to the inflation shock in 2022. Inflation peaked at 11.1 percent back then, the highest rate posted by any major economy.

The Bank’s change in outlook will make life doubly uncomfortable for the Labour government, which had hoped that its efforts to close the U.K. budget deficit would be rewarded with lower inflation and lower interest rates.

Instead, the government’s key 10-year borrowing costs have risen by nearly half a percentage point since the war started, and they leaped again on Thursday, first in response to Iranian attacks on a Qatari gas field, then to the BoE’s statement. At 4.89 percent, the 10-year gilt yield is now at its highest in 15 months. The pound, by contrast, was steady against the dollar and euro after the decision.

The Office for Budget Responsibility earlier this month already cut its forecasts for U.K. growth this year. That implies lower tax receipts which, combined with higher borrowing costs, threaten a new two-way squeeze on Chancellor Rachel Reeves’ fiscal arithmetic, less than six months after she had to raise taxes sharply at her latest budget.