BOE Assumptions Suggest Hawkish Tilt on UK Rates, Economists Say

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(Bloomberg) — The Bank of England may respond more aggressively than expected to soaring energy prices since war broke out in the Middle East because its internal models assume a large and long-lasting impact on inflation.

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Work published by the central bank at the end of last year suggests it will adopt “a more hawkish tone than we expect,” according to Dan Hanson, chief UK economist at Bloomberg Economics. Taking the analysis literally, the energy shock “could well prompt a screeching hawkish turn” from recent expectations of rate cuts.

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Hanson said he expects rates to be held unchanged at 3.75% when the bank announces its decision on Thursday, to buy time to respond to the rapidly evolving events. But the BOE “will probably say the recent rise in energy prices has shifted the balance of risks around the near-term inflation outlook to the upside,” he added.

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The analysis highlights the headwinds facing UK Chancellor of the Exchequer Rachel Reeves as she tries to spur economic growth. She’s repeatedly trumpeted the BOE’s six rate cuts since Labour came to power in 2024 as an indication that the UK economy is turning a corner, and until US and Israeli strikes on Iran sparked the current conflict at the end of last month, it had looked like the nine-member Monetary Policy Committee would have backed a quarter-point cut to 3.5%. Markets were pricing one further cut later this year.

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But with the war bringing Persian Gulf oil and gas traffic to a standstill, energy prices have soared, raising inflation expectations and dimming the prospect of further rate cuts boosting homeowners.

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The Office for Budget Responsibility and others have warned inflation may now end the year at 3% – a percentage point above the bank’s central forecast. Markets now put a 50% chance of a rate rise to 4% by December.

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Most economists expect the bank to look through the energy price spike, with the median of forecasts from a Bloomberg survey still anticipating two cuts to 3.25% this year. However, Hanson’s analysis of a BOE paper published in August found that the impact of higher oil prices “is about three times larger than our estimate.”

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“In other words, it’s possible the central bank judges the spike in crude will have a bigger impact on prices than we expect,” he said.

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A separate piece of work by the BOE in November showed household inflation expectations tend to respond to an energy supply shock like the one triggered by the war in the Middle East. Inflation expectations tend to prolong actual inflation because worker demands can trigger a wage-price spiral.

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“The logic is simple – energy is a salient component of the Consumer Price Inflation basket so it affects perceptions about the pace of price rises in the future,” Hanson said.

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Despite the BOE’s more hawkish assumptions, Hanson said it is unlikely to follow through with rate rises because unemployment is rising, meaning people “aren’t well positioned to push for higher wages.”

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“At the same time, demand is weak, making it hard for firms to push through price rises to protect their profit margins,” he added. “The central bank will almost certainly hold rates steady this week, citing uncertainty created by the war.”

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