The Bank of England has kept UK interest rates on hold as it warned that a further escalation in the Iran war could drive inflation above 4% next year, adding to cost of living pressures on households.
Against a volatile backdrop in the Middle East conflict, the Bank’s monetary policy committee (MPC) voted by six to three to keep its key base rate at 3.75%.
As Donald Trump’s renewed attacks on Iran drive up global energy prices, the Bank said an “adverse scenario” involving a drawn-out war and oil prices remaining above $100 a barrel could push UK inflation to a peak of 4.5% by the middle of 2027.
However, on a day of fresh US strikes in the widening conflict, Andrew Bailey, the Bank’s governor, played down suggestions among City traders that Threadneedle Street was edging closer to raising rates.
In a press conference after the decision, he said there was little sign that inflationary pressures were becoming entrenched because the growth outlook for the UK economy remained weak.
“Please do not leave this room thinking that the Bank of England is edging towards a [interest rate] hike because, frankly, there’s nothing in what I said, and I think any of us have said, along those lines,” Bailey said.
Official figures showed inflation in the UK fell by more than expected in June to 2.6%, down from a peak of 3.8% last year. It had been on track to fall close to 2% before the outbreak of the Iran war.
The Bank said a loose labour market and higher borrowing costs for households and businesses, compared with before the war, would reduce inflation over time. It added that conditions before the conflict were more “benign” than they had been before previous global shocks, including the Covid pandemic and Russia’s 2022 invasion of Ukraine.
The decision to keep interest rates unchanged is expected to give Andy Burnham a boost in his push to lower the cost of living. He has announced a sweeping package of support for households in his first week as prime minister.
Under his plans, electricity bills in Great Britain will be cut by an average of £45 a year from October by removing VAT from them. The Bank said it expected the policy, alongside a £2 cap on bus fares in England, to lower the headline inflation rate by 0.1 percentage point.
However, the MPC said it stood “ready to act as necessary” to prevent inflationary pressures from becoming entrenched.
Highlighting the risk of stubbornly high inflation, Catherine Mann, an external economist on the MPC, joined her fellow committee members Megan Greene and Huw Pill in dissenting against the majority of the panel with a vote to raise rates immediately to 4%.
Greene, another external member, and Pill, the Bank’s chief economist, had previously been outvoted in pushing for a quarter-point rise at the previous MPC meeting amid concern about inflation.
Financial markets had priced in a more than 90% probability of Threadneedle Street keeping borrowing costs on hold, with the outside chance of a rise. Investors expect a rise in borrowing costs to 4% before the end of the year.
The news comes after the Federal Reserve held borrowing costs unchanged on Wednesday and its new chair, Kevin Warsh, unnerved some investors worried over the US central bank’s readiness to tackle high inflation – leading to a rise in US government borrowing costs to the highest level since 2007.
Brent crude, the international benchmark for oil, briefly rose above $100 a barrel last week before falling back, amid fears that the violence across the Middle East could shatter the world economy’s earlier resilience to the Iran war. It was trading at a little below $90 on Thursday.
The Bank of England said that under its central forecast – involving the oil price falling back to about $71 a barrel – it still expected UK inflation to peak at about 3.2% later this year as households came under pressure from higher energy prices.
Under a milder scenario for the war, it said inflation would peak at about 3% before falling rapidly, leading the central bank to cut borrowing costs. However, economists said the situation remained highly dependent on how the conflict unfolded.
Paul Dales, the chief UK economist at the consultancy Capital Economics, said: “Much depends on what happens to energy prices and whether or not that leads to the second-round inflation effects that could transform a temporary rise in inflation into a longer-lasting one.”
While awaiting developments in the war, he said, “the BoE doesn’t seem to be moving closer to actually raising rates”.
