Bank of England rate hike case strengthens as UK energy shock risks persist

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Ashutosh Sureka

3 hours ago

Bank of England rate hike case strengthens as UK energy shock risks persist — BoE rate hike risks rise

A fresh energy shock linked to the war in the Middle East is reinforcing concerns that inflation in the UK could become more persistent. The risk, the analysis argues, is that higher household and company inflation expectations start feeding through to prices even if labour market pressures are weaker than in 2022.

Highlights

UK gas prices have risen above their 2011 peak, strengthening the case for a Bank of England rate hike amid persistent energy shock risks.
Household and company inflation expectations have risen sharply in 2024 following the conflict in Iran, driving up company year-ahead price forecasts.
A third supply shock in six years may make UK inflation harder to contain, heightening policy risk if the war persists and interest rate action is delayed.

Inflation expectations and policy risk

As reported by Financial Times, the argument for tighter Bank of England policy is building because the latest energy shock may generate second-round inflation effects before they become fully visible in wages and prices. The analysis says policymakers cannot yet know the full size of the shock while the conflict continues, but notes that gas prices have already risen above their 2011 peak, even if they remain well below 2022 levels.

Second-round effects emerge when households expect higher inflation and workers seek bigger pay rises to protect living standards, while companies raise prices to defend margins. In the UK, this mechanism matters particularly for gas because it has a strong influence on electricity prices and therefore on broader inflation.

Historical comparisons point to different outcomes after earlier energy shocks. In 2011, inflation peaked at about 5 per cent and the Bank of England kept rates unchanged, while in 2022 inflation climbed above 11 per cent and interest rates increased as expectations and labour market tightness intensified.

Why the UK may be more exposed now

The current backdrop sits between those two earlier episodes, with labour market conditions looser than in 2022 but tighter than in 2011. Household inflation expectations have already risen significantly this year after the conflict in Iran, and company year-ahead price expectations are also climbing sharply.

The analysis suggests the larger danger may now come through company price-setting rather than wage growth, because businesses facing another energy shock after years of margin pressure may feel more able to pass costs on when competitors are hit too. That may already be visible in the sharp rise in composite purchasing managers' index output prices since the war began.

A further concern is that this is the UK's third negative supply shock in six years, after a long stretch in which inflation has stayed above target. In that environment, households and companies may react more quickly to price increases than they did in either 2011 or 2022, raising the risk that inflation becomes harder to contain without higher interest rates if the war drags on.

In our earlier article on oil prices falling after signs of reduced U.S.–Iran escalation risk, we noted that crude retreated as traders pared back the “war premium” even while clashes in the Gulf continued. We also highlighted that uncertainty around the Israel–Lebanon ceasefire and ongoing risks near the Strait of Hormuz could still trigger sharp reversals in energy prices.

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