Bank of England warns ‘higher inflation unavoidable’ after holding interest rates

The Bank of England has left interest rates unchanged at 3.75% but said the UK may need to brace for increases later this year, as “higher inflation is unavoidable” as a result of the war in the Middle East.

The Bank’s rate-setting monetary policy committee (MPC) voted to leave borrowing costs on hold, but said that if energy costs stayed persistently high it might have to take a more “forceful” response to keep inflation under control.

The nine-member MPC was split 8-1 in its decision to keep borrowing costs on hold for the third consecutive meeting. Andrew Bailey, the governor of the Bank of England, said: “Where we go from here will depend on the size and duration of the shock to energy prices” as the conflict in the Middle East evolves.

The Bank outlined a worst-case scenario in which the price of oil rose above $130 a barrel and remained elevated for a prolonged period. It predicted that if this – which it called scenario C – happened, inflation would probably peak at 6% by the start of 2027, unemployment would rise to 5.6% and interest rates would have to rise to 5.25% to combat this.

Bailey said: “The longer this problem goes on and the longer the disruption to energy supplies goes on, the more difficult the scenario we’re in.”

However, the governor added that the decision to hold rates at 3.75% for now was reasonable “given the situation of the economy and the unpredictability of events in the Middle East”.

Bailey said there was also a chance that interest rates remained unchanged this year if the Iran war was resolved quickly.

The MPC’s role is to try to help keep UK inflation at a target of 2%. It has cut interest rates six times since mid-2024 and had been expected to make further reductions this year before the US-Israel war on Iran began.

The Bank said the conflict in the Middle East meant the outlook for inflation was “a very different picture from three months ago” when it was expected to fall to 2% by the middle of the year. Instead, the latest figures from the Office for National Statistics showed the rate of UK inflation, as measured by the consumer prices index, rose to 3.3% in March, up from 3% in February.

The sharp rise in energy prices is already being felt in the UK in the form of higher fuel costs. Officials at the Bank said typical energy bills were likely to rise 16% to £1,900 by the summer. Food inflation is also expected to rise 7% by the end of the year because of higher prices for fertiliser, energy and transport.

While policymakers believe global energy prices will have a direct effect on pushing up fuel costs and utility bills, they expect the impact of “second-round effects” to be more restrained. The Bank said demand for labour in the UK was subdued and that unemployment had been rising since 2024, making it harder for workers to bargain for higher wages. Similarly, companies’ ability to increase prices was likely to be constrained by weak demand amid shaky consumer confidence, it added.

The only dissenting voice in this decision was Huw Pill, the Bank’s chief economist, who voted to raise rates to 4%. Pill said he saw the risk of second-round effects of higher prices and wages being “skewed to the upside” and said they had the potential to raise UK inflation beyond the near term in a “persistent manner”.

The Bank laid out three scenarios for what might happen to the UK economy depending on different impacts of the Iran war. In all three cases, inflation is expected to rise, and unemployment will go up to at least 5.5%.

Policymakers cautioned away from their worst case scenario of oil staying at $130 a barrel for the rest of 2026 and said they were more closely following a situation in which oil peaks at $108 a barrel this year.

Earlier on Thursday, Brent crude hit a four-year high of $126 a barrel, but has now dropped back to $115.50 a barrel.

In the Bank’s scenario A, in which oil prices come down quickly from $108, inflation will be 3.3% in 2026, 2.6% in 2027 and 1.5% in 2028. In scenario B, where oil stays at $108 for longer, inflation is also 3.3% in 2026, then 3% in 2027 and 2% in 2028. Under both scenarios, unemployment rises to 5.5% in 2027 and then falls to 5.4% in 2028.

Bailey told a press conference on Thursday the decision was “a deliberately, active hold”.

“It is not the case that we’re sort of giving some sort of slightly clandestine message that interest rates are going to go up,” he said, although the Bank’s modelling suggests interest rates might need to rise under scenario B as well as C.

The City money markets lowered their expectations for rate rises this year slightly after the Bank’s decision was announced. They are now pricing in about 62 basis points (0.62 of a percentage point) of increases by the end of 2026, down from 70.

Separately, the European Central Bank voted to keep its interest rates on hold, at 2%, but said the Iran war meant risks to inflation rising and growth shrinking had “intensified” across the eurozone.

Christine Lagarde, the ECB president, said the final decision to hold rates was unanimous but told a press conference that a possible increase had been discussed “at length” by policymakers. She said the next meeting in June would be the “right time” for a new assessment when policymakers had more information on the impact of the war on the economy.

Echoing Bailey’s comments, Lagarde said: “The longer the war [in the Middle East] continues and the longer energy prices remain high, the stronger is the likely impact on broader inflation and the economy.”