Oil price surge hits UK inflation rate, potentially returning to 5% high; Bank of England's rate cut dreams dashed this year

The surge in oil and gas prices triggered by the Middle East conflict is posing a significant inflation risk to the UK, according to estimates released Monday by ING and RSM UK. If recent increases in oil and gas prices persist, the UK’s inflation rate could rise to more than twice the Bank of England’s 2% target. Previously, Brent crude oil broke above $100 per barrel for the first time since 2022. ING economist James Smith said that if oil prices continue to rise in the second quarter, inflation could reach 4.7% by September. RSM UK economist Tom Pugh estimates it could lead to inflation between 4.5% and 5%.

Since summer 2024, the Bank of England’s Monetary Policy Committee has gradually cut interest rates from a peak of 5.25% to 3.75%, as inflation threats have eased. However, sharp volatility in energy markets on Monday has also caused significant shifts in market expectations for BoE policy.

With the UK facing the prospect of inflation possibly rebounding to as high as 5%, traders are increasing bets that recent rate cuts could be reversed. Three weeks ago—before the US and Israel launched attacks on Iran—markets expected the BoE to make two more 25 basis point rate cuts this year, lowering rates to 3.25%, with an 80% chance of a cut at the March 19 policy meeting. Before the Middle East conflict erupted, the BoE forecast inflation would fall to its 2% target in spring. Now, markets expect no further rate cuts this year, with some even pricing in a 60% chance of rate hikes. As a result, the UK mortgage market has already been affected—average two-year fixed mortgage rates rose from 4.82% to 4.87% in less than a week.

Beyond the Bank of England, the sharp rise in inflation also poses a major challenge to the UK Labour government, which has previously pledged to address the cost of living. After G7 finance ministers discussed increasing oil supplies on Monday to ease the situation, UK Chancellor Jeremy Hunt said she would support a plan to “coordinate the release of collective oil reserves.” Prime Minister Rishi Sunak also stated Monday that the UK has the capacity to handle this global shock. Despite economists raising their forecasts, Sunak emphasized that recent inflation has declined and noted that Labour has done “a lot of work over the past 18 months to strengthen the economy’s resilience.”

However, some economists believe the UK is less affected by the energy shock. Bloomberg Economics UK economist Dan Hanson and Anna Andrad said that if oil prices stay at $100 per barrel and natural gas remains at £1.50 per therm, then fall back to $80 per barrel as market expectations suggest, UK inflation could be “slightly below 3% by year-end.” Even so, this is still about 1 percentage point higher than the Bank of England’s latest forecast.

Rob Wood, Chief UK Economist at Pantheon Macroeconomics, offers a more conservative estimate. He expects UK inflation to decline in the coming months but not fall to the BoE’s 2% target, then rise above 3% in the second half of the year.

Dan Hanson and Anna Andrad wrote, “We believe that in the face of such a shock, the Bank of England may keep interest rates unchanged this year—weak labor markets mean the threshold for tightening policy is high.”

James Smith also pointed out that a weak labor market could limit the second-round inflation effects, which previously kept inflation high after the energy shock triggered by the Russia-Ukraine conflict in 2022. He said, “Given that the cap on household energy prices in the UK is based on a three-month average of wholesale prices, the duration of high prices may be more important than the peak level.”

After being criticized for acting too slowly to address price pressures caused by the Russia-Ukraine conflict—when inflation briefly exceeded 11%, and a tense labor market made it harder to curb price increases—Bank of England officials may become more cautious about any energy shocks.

Martin Weale, a former Bank of England rate-setter and now a professor of economics at King’s College London, previously stated that the Monetary Policy Committee “is likely to remain highly alert to energy price increases after experiencing the last round of energy price spikes.” Rising energy prices can boost inflation while suppressing economic growth. Weale said the BoE cannot offset this economic shock but can try to prevent a wage-price spiral. He implied he would not support rate cuts and said, “If I were still on the MPC, I would be concerned about further stimulating demand at the current inflation level.”