Just a few weeks ago, investors were confident that the Bank of England (BoE) would continue cutting interest rates this spring. But the surge in global energy prices has forced markets to rethink. Traders had almost fully priced in a March rate cut and expected the base rate to fall to 3.25 per cent – or even 3 per cent – later this year. As inflation risks have risen, that confidence has quickly evaporated. At the time of writing, traders were assigning more than a 50 per cent chance to the BoE leaving rates unchanged all year.
The shift reflects growing concern about the inflationary impact of conflict in a resource-rich region. Unrest has disrupted energy production and exports across the Middle East – some liquefied natural gas processing plants have been forced to suspend operations, while others are struggling to export fuel because of disruption to shipping routes.
Energy markets have reacted quickly. Oil prices briefly spiked to $120 ($89) a barrel, and were hovering around $90 a barrel at the time of writing, up from around $60 a barrel at the end of last year. Gas prices have climbed sharply, too, with the European benchmark price at one point reaching €60 (£52) per megawatt-hour (MWh), before retreating to €47/MWh.
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What this means for inflation
Before the conflict escalated, forecasters expected UK inflation to return to the BoE’s 2 per cent target as early as April. If commodity prices stay close to current levels, that timeline will slip. Analysts at Pantheon Macroeconomics say the inflation target may not be reached for another year if energy prices remain elevated.
Even so, the shock is unlikely to match the surge that followed Russia’s invasion of Ukraine in 2022. Pantheon economists say that the latest shock is “nowhere near as big”, and expect inflation to peak at around 3 per cent. Analysts at Capital Economics estimate that the conflict could add between 0.3 and 1.2 per cent to UK consumer price index inflation this year, depending on its duration. Given US President Donald Trump’s vow that the war will be over “very soon”, the figure could be at the lower end of the spectrum.
What this means for interest rates
In normal circumstances, central banks can ‘look through’ temporary energy shocks. But today’s shock might have an outsized influence on how households perceive inflation. Research suggests consumers respond strongly to changes in energy costs: when electricity prices rise by 1 percentage point, households’ average inflation expectations increase by around 0.13 percentage points.
These rising expectations can create a feedback loop: workers demand higher wages to keep up with expected price increases, while firms raise prices in anticipation of higher costs. If current trends continue, by early 2027 inflation will have been above the BoE’s target for almost six years. If households don’t believe that inflation will return to ‘normal’ soon, it will be far more difficult for policymakers to dismiss a spike as a transitory shock.
Despite changing market expectations, few economists expect interest rates to rise again. Analysts at Capital Economics think that the greater risk is that rates simply stay where they are this year. Nevertheless, the big shift in rate cut expectations has left gilts vulnerable. Ten-year gilt yields, a benchmark for government borrowing costs, have risen from 4.25 per cent since the end of February, at one point hitting 4.75 per cent. Two-year yields, which are more sensitive to expectations for central bank policy, have risen even more sharply, climbing from 3.52 per cent to a brief peak of 4.13 per cent over the same period (see chart).
The UK’s vulnerability to energy shocks partly reflects our reliance on imported fuel. According to the International Energy Agency, net imports account for 48 per cent of the country’s energy supply. This is better than Germany (70 per cent), but far higher than in the US, which has become a net exporter of energy following a substantial increase in oil and gas production. This difference may shape how monetary policy evolves on either side of the Atlantic.
According to the CME FedWatch tool, markets only see an even chance of a US rate cut from July onwards, and are pricing a 20 per cent chance that there will be any easing this year. For the US economy, higher oil prices could provide an economic boost by stimulating domestic energy production. The effect would still be inflationary, but through stronger economic activity, not higher import costs. In the UK, the problem is more difficult to solve. Rising energy prices will push inflation higher while simultaneously weighing on economic growth.
