Bank of England likely to hold interest rates as Iran conflict fuels energy shock

Bank of England interest rates were widely expected to be cut this month, but surging oil and gas prices linked to the Middle East conflict have shifted market expectations towards a hold, with economists warning borrowing costs could rise above 4%.

The central bank held rates at 3.75% last month in a narrow 5-4 vote, but the war in Iran has cast doubt over its ability to deliver further cuts. Traders have sharply reduced their bets on a rate reduction later this month, from an 86% chance on Friday to just 27% today, after the Middle East conflict triggered the sharpest oil (BZ=F, CL=F) and gas (NG=F) shock since Russia invaded Ukraine in 2022. Money markets now expect only one more cut this year, from 3.75% to 3.50%, down from two last week.

The National Institute of Economic and Social Research (NIESR) said higher energy prices could push inflation higher and raise borrowing costs. Ben Zaranko, from the Institute for Fiscal Studies, added that rates may need to rise to keep inflation in check, noting that the Office for Budget Responsibility’s modelling suggests the Bank of England could be forced to raise borrowing costs.

Ed Cornforth, an economist at NIESR, said: “The conflict in the Middle East will have material implications for the economic outlook. The Bank of England will have to contend with a shock to global energy prices, with the question of persistence hanging over their heads.”

Zaranko added he would not “rule out” a rate increase to 4% as the BoE’s next move. “In the short term, what we might see is rather than rates go up it might just mean rate cuts we might otherwise have experienced don’t happen,” he said.

Oil and gas prices have jumped since the US-Israel war with Iran intensified, disrupting supplies. Iran has threatened to block the Strait of Hormuz, while Qatar halted liquefied natural gas (NG=F) production following attacks on its plants. Brent crude (BZ=F) has risen about 15% since the fighting began, and European natural gas prices have soared by roughly three-quarters.

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James Smith, developed markets economist at ING, said: “Investors have slashed expectations for a March rate cut from the Bank of England. Markets are pricing it with just a 20% probability, down from 80% pre-conflict. We now expect the next cut in April, though March remains possible if tensions rapidly de-escalate. With the jobs market still under pressure, further easing is still more likely than not.”

David Rees, head of global economics at Schroders, said rising energy prices could offset the impact of the April budget and give the BoE pause. “If higher energy prices squeeze real incomes and prevent the bank from cutting rates, hopes for a growth pick-up could be dashed, potentially forcing action from the chancellor later this year,” he said.

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Andrew Hunter, senior economist at Moody’s, added that spikes in crude and natural gas prices could push consumer price inflation higher, while the UK 10-year gilt yield has risen above 4.5% from around 4.2% last week. He said the situation illustrated the UK economy’s vulnerability to external shocks and the ongoing pressure on public finances.

Capital Economics has warned that slower UK interest rate cuts are more likely than rate hikes. Ruth Gregory, its deputy chief UK economist, said: “While parallels are being made with the energy price shock caused by the Russia-Ukraine war in 2022, the rise in energy prices as a result of the conflict in the Middle East has so far been smaller than that in 2022 and the economic backdrop is very different.”

“So unless energy prices rise further and/or a major fiscal stimulus is announced, slower interest rate cuts are more likely than interest rate hikes.”

Earlier this week, Bank of England policymaker Alan Taylor said that it was too early to assess how the conflict in the Middle East would affect Britain’s sluggish economy.

Asked about the potential impact on inflation and growth, Taylor told a conference hosted by Norway’s central bank: “I think it’s really too soon to tell. That’s something we’re going to have to keep an eye on as the situation evolves in real time … the outlook is very fluid.”

Taylor said some large inflation shocks cannot be solved by central banks. “Central bank mandates should be strong yet flexible. History demonstrates that as the economy evolves, central bank strategies have adapted over time to reflect this reality,” he said. “We also need to acknowledge that central banks and their mandates can never fully solve every type of inflation problem, including the big shocks of recent years.”

In Europe, ECB policymakers warned that eurozone inflation could rise if the conflict continues. Vice-president Luis de Guindos and the central bank governors of Germany and Finland said a prolonged war may push inflation higher, even as they cautioned against drawing early conclusions. Bundesbank president Joachim Nagel said lasting high energy prices would lead to both higher inflation and weaker growth, while a swift resolution would limit the impact.

In the US, oil (BZ=F, CL=F) price spikes have led Federal Reserve officials to adopt a wait-and-see approach. Investors now expect a 25 basis point rate cut to be delayed from July to September.

Daniela Hathorn, senior market analyst at Capital.com, said: “The Federal Reserve’s policy outlook is becoming more complicated. A prolonged energy shock would reduce flexibility for rate cuts, particularly if headline inflation reaccelerates. That risk is now being priced into markets in real time.”

The outlook is further complicated by leadership changes at the Fed. Kevin Warsh, president Donald Trump’s nominee to succeed Jerome Powell when his term expires on 15 May, is widely expected to favour lower interest rates even amid rising oil (BZ=F, CL=F) prices.

In the run-up to his nomination, Warsh said rates should be below the current federal funds range of 3.5% to 3.75%, a view Trump has cited in selecting him, signalling that the Fed’s approach to inflation and rate cuts could shift sharply under new leadership.

The Bank of England is scheduled to announce its interest rate decision on 19 March around noon.

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Bank of England likely to hold interest rates as Iran conflict fuels energy shock

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