Rising oil prices could force up UK interest rates, say economists | Interest rates

The Bank of England may be forced to tear up its economic forecasts and raise interest rates towards the end of this year if oil prices rise above $100 a barrel, City economists say.

Ahead of Thursday’s meeting of bank officials, economists said that while a rate hike will likely be avoided this week, a rise could happen in the future due to conflicts in the Middle East.

The UK economy has remained relatively resilient since Donald Trump’s war against Iran began in March, but this could be at risk after hostilities reignited last week, economists added.

The breakdown of the fragile ceasefire between the United States and Iran has caused oil prices to return to the highs seen in April and May, fueling fears that higher prices at the pumps will lead to higher inflation.

Brent crude rose above $100 (£75) a barrel on Thursday and fell to $96 a barrel on Friday, well above the $71 recorded earlier this month.

Gas prices rose before the critical period when most European countries refilled storage facilities in time for winter heating demand.

All major central banks say they are concerned about the impact of war in the Middle East and rising prices.

The bank’s nine-member monetary policy committee is expected to vote on Thursday in favor of keeping interest rates steady, voting by a seven-to-two margin to keep interest rates at 3.75% until at least December. This is reminiscent of the last meeting in June, when two officials on the committee voted to raise rates to prevent rising inflation.

Sanjay Raja, Deutsche Bank’s chief UK economist, said the calculus could change if the intensity of air strikes continued and sea channels that allow tankers to enter and exit oil terminals remained closed.

“We see upside risks to the interest rate outlook in the near term, and these risks depend largely on the duration of the energy shock. A second energy wave will likely increase uncertainty in the inflation path and the risk of a second-round effect.”

George Buckley, Nomura’s chief economist for the UK and Eurozone, said financial markets were giving a clear signal that higher oil prices would translate into higher interest rates. “At $90, a one and a half quarter point increase will be needed. At $100, two increases of 25 basis points will be needed,” he said.

Mohamed El-Erian, a professor at the University of Pennsylvania and former chief economist of the International Monetary Fund, suggested that a sustained rise in oil prices to $90 a barrel could be enough to rewrite UK policymakers’ forecasts.

He said: “If oil prices remain above $90 a barrel, a significant ‘if’, then headline inflation will face significant upward pressure. This will raise concerns about direct indirect impacts, including rising food prices driven by diesel transport costs and broader second-round effects over time.”

“The result will be increased market expectation of a Bank of England interest rate hike, even as higher energy prices act as a tax on economic activity.”

Ruth Gregory, deputy UK economist at Capital Economics, said the worst-case scenario showed interest rates in the UK would likely rise from 3.75% to 4.75% if inflation rose to 7% in the coming months in response to conflict in the Middle East.

Harvinder Kalirai, chief global currency strategist at Alpine Macro, a division of Oxford Economics, said he expected the Bank to “take into account the oil shock and political noise” to keep interest rates steady for now before resuming cuts next year.

He said the UK was not strong enough to withstand the rise in the cost of fuel and higher interest rates: “Demand is not strong enough to sustain the transition of the energy shock, forcing firms to absorb higher input costs.”

Kalirai said that excluding volatile elements in the inflation basket, including fuel and food, prices are increasing slowly, while salary packages are increasing more slowly.

Costas Milas, professor of economics at the University of Liverpool, said that shocks in oil prices trigger long-term inflation crises and these shocks must be overcome quickly.

He said: “The BoE’s inaction is very troubling, not least because of the inaction of the public. I am not happy with BoE. “As dissatisfaction with inflation grows, the BoE should take action by increasing interest rates, perhaps as early as September.”

David Aikman, chief executive of the National Institute of Economic and Social Research, said: “The longer inflation stays above target, the greater the change in inflation expectations and wages respond – which is why the Bank needs to raise interest rates.”

Financial markets also expect a rate hike at the next meeting of the European Central Bank’s governing council on September 10. It raised interest rates in June for the first time since 2023 in response to high inflation caused by the war in Iran.

Central banks have come under fire for considering raising borrowing costs, with critics arguing that an increase in interest rates will only make a bad situation worse.