Interest rates may rise due to Iran shock

The Bank of England may consider raising interest rates this year if energy prices do not revert to pre-conflict levels with Iran, according to leading economists. Analysts from City and Westminster think tanks suggest that heightened inflation, driven by disruptions in oil and gas flows through the Strait of Hormuz and broader Middle Eastern energy production, could hinder the Bank’s plans to lower borrowing costs.

This week, Brent Crude Oil’s spot price climbed to approximately $81, marking a rise of over 10% since last Friday. UK natural gas prices also surged, more than doubling, before easing on Wednesday. Analysis by the National Institute for Economic and Social Research (NIESR) indicates that a temporary increase in oil prices to $100 per barrel, if resolved within three months, could add 0.3 percentage points to inflation. However, a year-long economic shock could increase inflation by 0.7 percentage points and reduce growth by 0.2 percentage points.

Treasury and Office for Budget Responsibility (OBR) officials confirm that a general rule of thumb measures the impact of energy market price increases on inflation, with a 20% rise in gas and oil prices potentially adding one percentage point to inflation.

Ed Cornforth, an economist at NIESR, highlighted the Bank’s challenge with the “question of persistence” in oil and gas prices before making any interest rate decisions. Ben Zaranko, director at the Institute for Fiscal Studies (IFS), noted that an interest rate rise above the current 3.75% could not be excluded, as markets have largely dismissed the possibility of a Monetary Policy Committee (MPC) rate cut this month. “The MPC will aim to overlook any temporary inflation spikes, but repeated shocks may influence household expectations,” Zaranko stated.

Significant revisions to UK inflation and interest rate forecasts would adversely affect the forecasts established in this week’s Spring Statement. During the Statement, Reeves emphasised a modest increase in fiscal headroom to £23.6 billion, following OBR’s projection of lower interest rates reducing government lender payments by 2030. Higher interest rates could frustrate Labour’s economic plans.

Reeves met with executives from North Sea oil companies BP, Serica, and TotalEnergies in London to discuss energy price rises, sparking speculation about potential regulatory easing to alleviate pressure on UK consumers. It is reported that the Chancellor intends to replace the energy profits levy with a revenue and market price-based tax mechanism, as previously announced, although policy uncertainty remains due to Middle Eastern conflict.

A government source stated: “The Chancellor was clear with the industry about ending the energy profits levy. She remains committed to this promise, but the Middle Eastern crisis has immediate repercussions on oil and gas prices, necessitating a response.”