Inflation is looming: will it make the Bank of England act?

March’s inflation print is one of the first bits of hard data to highlight the UK macro impact of the Iran war. Y-o-y UK CPI rose from 3% in February to 3.3% in March, and inflation is now on course to peak at around 4% later this year. This is, of course, in marked contrast to the Bank of England’s February forecast of inflation falling to near target level in April and then staying at around 2% for the remainder of the year. 

A large degree of uncertainty remains about how severe the energy price shock from the Iran War will be, although we know for sure that there will be an impact, as multiple energy infrastructure sites in the Middle East have been destroyed or damaged. But it is important to stress once again that there’s unlikely to be a repeat of what happened in 2022 when Russia invaded Ukraine. Monetary policy was loose in the run up to the invasion, whereas we come into this energy price shock with interest rates at levels that are likely to be restrictive to economic activity. Moreover, the broad-based supply disruptions arising from Covid are not present this time around (see, for example, what happened with shipping costs in Figure 1 below). 

However, there is no doubt that the current crisis has exposed some of the UK’s structural vulnerabilities. For example, compared to other developed economies the UK is very reliant on gas for its energy mix, and of course a large amount of this is imported. And at various points over the past couple of months, the gilt market has seen higher levels of volatility compared to other G7 debt markets. A big reason for this is that the UK’s gilt market is disproportionately reliant on overseas investors who are typically more mobile than, say, domestic pension fund investors. This is, of course, not to mention that yields on gilts have for some time now been notably higher than those of G7 counterparts (see Figure 2), in no small part due to perceived inflation risks in the UK.  

Looking ahead, how will the Bank of England react to the upcoming increase in short-term inflation? As highlighted in the previous Rate Wrap, the jump up in consumer inflation expectations will clearly be a concern, especially since the public is now more attentive to inflation. Apart from a brief period in 2024, the UK has not met its inflation target for nearly five years now. However, as the labour market has somewhat loosened over the past two years or so (see Figure 3), consumers may not be in a position to demand large increases in wages in the way they did following the 2022 inflation spike. This could help quash any unwelcome wage-price dynamics playing out. 

Nonetheless, our base case view is that the Bank of England will need to respond to the risk of second-round effects from the short-term inflation spike, potentially leading to one rate hike this year, a change from the pre-Iran war prediction of two rate cuts. But there is a huge level of uncertainty. If the geopolitical situation sees a rapid de-escalation, it is plausible that we end up seeing a couple of rate cuts later this year whereas in an escalatory scenario we could see several rate hikes. The situation will almost certainly be clearer by the time of the next Rate Wrap, although more column inches may end up being dedicated to UK political risk given current instability in the government and the upcoming May local elections.

Daniel Mahoney, UK Economist

How far must the Old Lady factor in Iran war effects? 

The Bank of England’s Monetary Policy Committee doesn’t have another base rate decision to make until the end of this month, on April 30, which could be a blessing in disguise given the high level of uncertainty we’ve had this month amidst the ‘will-they won’t-they’ prospect of a ceasefire between the US and Iran. 

The MPC’s minutes from its previous meeting in March said it expects inflation of “close to” 3.5% in March, so the revelation on April 22 that it was ‘merely’ 3.3% was particularly welcome. Progress lately towards a hopeful peace-deal in the Middle East had seen Brent crude oil spot prices cool to under $100pb, even despite the US attack on and subsequent seizing of an Iranian tanker on Sunday April 19. Whilst this is still considerably higher than before the onset of the conflict, it does suggest that the peak for inflation may be lower than previously feared. That being said, as Jasmine discussed in last month’s Rate Wrap, a cessation of hostilities in the Middle East doesn’t mean that we suddenly revert to February’s rate-path of expecting two base rate cuts this year. 

Shipping through the Strait of Hormuz, although up slightly from its typical March 2026  levels of 0-1 ships per day, is still considerably far below peacetime levels (average 57.2 ships per day) with the Iranians blockading one end of the strait and the US navy the other. The weekend following the announcement of the US blockade (Saturday April 11 and Sunday April 12) did see an increased average of 16 ships per day transit the strait, but this is clearly still in restrictive territory.

At time of writing, the markets are looking at a rate hold on April 30 then a hike in either July or September, to 4.00%, with one more seen as about 60% likely from November onwards but swaps markets pricing suggest it’s quite possible for base rate to remain at 4% indefinitely, as particularly evidenced by the rather miniscule 1bps spread between the 2-5 year SONIA swap rates. Rather than seeing the Bank of England hike once and then keep the rate steady for up to five years, which I feel is unrealistic, I believe this is more a reflection of traders’ uncertainty – they still think there’s a risk of stickier inflation which may warrant that first base rate hike, but are finding it hard to form expectations beyond that.

The Bank of England will need to be keenly aware of second-round inflation effects, for example higher energy costs leading to higher shop prices, which themselves may lead to increased wage demands later in the year. Even if the UK government does announce some form of support for households to cope with higher energy bills it seems less likely that this will be extended to businesses, heightening the inflation risk more than anything as business costs will increase and households will retain more of their disposable income to help afford higher prices. It’s possible that some of the larger retailers may already be building in some higher consumer prices to try and get ahead of future volatility in energy costs, particularly for freight shipping or haulage. 

Another concern there is that businesses with large exposure to energy markets, including but not limited to energy companies themselves, would typically fix forwards their costs to some degree using the futures markets. Presently the forward curve for UK natural gas is still showing a substantial increase from its pre-Iran War levels, most notably in the shorter term, but it remains higher for at least five-years ahead. This means that even if spot energy prices revert back to pre-conflict levels, the cost to households and businesses will likely remain sticky, although to what extent is uncertain. I do think however that the current climate of heightened volatility and uncertainty may well have encouraged companies to alter their hedging policies to fix an even higher proportion of their future requirement than they were doing previously. 

The word stagflation has reared its ugly head of late, but the big question for the Bank of England is which side of that coin will prove stronger; will tepid economic growth sufficiently cool aggregate demand to outweigh the cost-push inflationary pressures ? The International Monetary Fund has downgraded its 2026 growth projections for the UK to 0.8%, but there was some good news on April 16 when the February GDP print came out stronger than expected at 0.5% monthly growth, much better than expectations of 0.1% and the revised January print of -0.1%! 

The upside surprise was primarily driven by the services sector and supported by a rebound in manufacturing and construction. With this all being before the onset of the US-Iran conflict, it at least shows the UK economy will have borne the brunt of that macroeconomic shock from a relatively stronger position. This may be why markets haven’t been keen to fully price-out the prospect of base rate rises despite the situation seeming tentatively more benign.

When discussing interest rates we typically focus on the impact of inflation, but of course there are other factors too. One that has resurfaced in the UK yet again is political risk, particularly from the ongoing Mandelson scandal. On April 16 we saw calls for Prime Minister Keir Starmer to resign after it was revealed that the Foreign and Commonwealth Development Office granted Peter Mandelson’s security clearing despite objections from vetting officials. The UK’s Ministerial Code states that ministers should resign if they knowingly mislead parliament, and Sir Keir did address the House of Commons on Monday 20, adamant but not entirely convincing that it was not committed knowingly as he himself had been misled in the first place. This was then followed the next day by testimony to Parliament by Sir Olly Robbins, the former head civil servant of the Foreign, Commonwealth and Development Office.

The initial market reaction on April 16 was a fairly muted softening of gilts, with yields initially up by about 3-6bps with more of a reaction seen in the longer end. This in turn also dragged up swap rates, with 5-year SONIA swaps reacting by climbing 5bps over the following few hours but then reverting back to similar levels the next day. April 20 and 21 were also marked by small upwards movements in swap rates but nothing too major. Still, it gives a small hint at the direction of travel for rates markets should there actually be a change of premier.

Even with Sir Keir remaining in office for now, things could well change should Labour suffer heavy losses in the early-May local elections. The chief concern for investors of a change in prime minister at this stage is the lack of an obvious heir-apparent, meaning a lot of uncertainty over who might take over and how much they may want to change policy. The main fear for rates markets is that the new prime minister may also want to also bring in a new chancellor who may be more willing to loosen the purse strings, raising the risk of an increased supply of gilts leading to even higher yields and swap rates. 

Hotter inflation and cooler consumption poses a problem for the Fed

The US Federal Reserve is meeting on April 29, the day before both the Bank of England and the European Central Bank. Markets currently see a mere 1% chance of a hike, with expectations currently set for the target rate to remain steady for the foreseeable future, with c.49% chance of one 25bps cut coming over the next 12 months. 

Returning again to the dreaded prospect of stagflation, the market’s expectation of cuts could be surprising given that March’s CPI print came in hot at 3.3% on an annualised basis, up from 2.4% in February, making it the biggest monthly increase in almost four years. A large part of this will be March’s 21.2% increase in gasoline prices, itself the biggest monthly increase since records began in 1967. Whilst most central banks will indeed be initially ‘looking through’ the March inflation data as a swifter resolution to the war in Iran could bring it down considerably, as I’ve discussed above there’s no guarantee that price-growth cools to its pre-conflict trajectory.

One complication is that the import price index for March showed growth of 2.1%, much lower than anticipated at 4.4% year-on-year although still a big increase from February’s figure of 1.0%. No doubt this was helped in part by the Supreme Court’s ruling on IEEPA-based tariffs having reduced the overall effective tariff rate on China. The April importers price data will be key to seeing if the increase in import prices remains less bad than feared, or if price rises were just pushed further out. 

Meanwhile, February personal income and spending figures came out considerably worse than anticipated, suggesting the real US economy is bearing the brunt of the Iran War disruption from a weaker footing than previously thought. Some economists’ expectations now are for merely 1% growth to US consumer spending in Q1 and the Q2 print could be even weaker still.

Overall this strikes me as surely posing a problem for the Federal Reserve: will weakening consumption drag sufficiently on aggregate demand to outweigh the cost-push pressures from energy prices? I feel a lot will depend on how four key questions play out over the coming months:

• If there is a peace-deal reached that it will be upheld by all parties (we’ve already seen each party breach interim ceasefire agreements);
• Inflationary pressures are more transitory than sticky (like 2022 all over again) e.g. what will be the impact on consumer prices if tolls are charged to transit the strait, insurance premiums for shipping remain elevated to account for the risk of further conflict, will ship crews demand higher wages to transit the strait?
• Can energy and fertiliser production return quickly to pre-war levels i.e. minimal long-term damage to infrastructure – we already know this won’t be fully true but to what extent is unclear; and
• Will there be a new macro-economic shock elsewhere in the world e.g. does the concentration of US naval forces in the Middle East encourage China to put pressure on Taiwan, perhaps via a blockade of its own? Is the threat of a heavy loss in November’s mid-term elections encouraging President Trump to switch focus to the domestic economy, or will he strive for a big policy win elsewhere such as regime-change in Cuba?

Until some more clarity is reached, I feel markets will struggle to firm-up any set of interest rate expectations. Expect a bumpy road ahead.