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The Bank of England could raise interest rates this year if energy prices fail to return to levels seen before the start of America’s war with Iran, leading economists have warned.
Analysts across the City and at Westminster think tanks have suggested that higher inflation caused by disruption in oil and gas movements across the Strait of Hormuz and to wider energy production across the Middle East could derail the Bank’s plans to ease borrowing costs.
On Wednesday, the Brent Crude Oil spot price rose to around $81, representing an increase of just over 10 per cent on prices last Friday. UK natural gas prices had more than doubled this week but eased back on Wednesday.
Analysis from the National Institute for Economic and Social Research (NIESR) suggested a temporary rise in oil prices to $100 per barrel and that subsided within three months would add 0.3 percentage points to inflation.
An economic shock that lasted one year, however, could push inflation by 0.7 percentage points and knock 0.2 percentage points off growth.
Treasury and OBR officials have confirmed that a rule of thumb is used to measure the impacts that higher prices in energy markets have on price growth. A 20 per cent increase in gas and oil prices is believed to add one percentage point to inflation.
Ed Cornforth, an economist at NIESR, said the Bank would have to contend with the “question of persistence” in oil and gas prices ahead of any decision on interest rates.
Ben Zaranko, a director at the Institute for Fiscal Studies (IFS), said an interest rate rise above four per cent from its current rate of 3.75 per cent could not be ruled out given markets had all but dismissed the possibility of a cut being made by the Monetary Policy Committee (MPC) later this month.
“The MPC will want to look through any temporary spike in inflation but this is one in a series of one-off shocks so they might worry about what that does to household expectations,” Zaranko said.
The Dutch bank Rabobank meanwhile said it did not forecast any other interest rate cuts this year as higher oil prices would “feed through quickly” in UK inflation.
Schroders economist David Rees said any pause to interest rate cuts would leave hopes “dashed for a growth pick-up” while Capital Economics’ Paul Dales said it would leave Rachel Reeves with a lower level of headroom.
Radical revisions of the UK’s inflation and interest rate forecasts would deal a blow to the Labour government which has staked its economic fortunes on falling borrowing costs.
At Tuesday’s Spring Statement, Reeves hailed a small rise in the fiscal headroom to £23.6bn, which came as the Office for Budget Responsibility (OBR) suggested lower interest rates would reduce the size of the government’s payments to its lenders by 2030.
Higher interest rates to frustrate Labour
The government has also talked up its policy to strip energy subsidies from household bills, leading Ofgem to lower the energy price cap by £117, equivalent to seven per cent. The Resolution Foundation warned, however, that should recent rises in oil and gas prices stick, some £500 could be added onto energy bills later this year.
Reeves met executives from North Sea oil giants BP, Serica and TotalEnergies in London to discuss energy price rises, fuelling speculation the government could ease regulation on businesses to ease pressures on Britons.
It is understood the Chancellor said she would look to replace the energy profits levy with another tax mechanism based on revenue and market prices, as previously announced by the government, though there was greater uncertainty over policy in the face of the conflict in the Middle East.
A government source said:”The Chancellor was clear with industry that she wants the energy profits levy to come to an end. She has made that promise and she stands by it. Indeed, it was a commitment she wanted to make this week. But the crisis in the Middle East has had real-time consequences on oil and gas prices and it is right that we respond to this.”
Sir Keir Starmer said during Prime Minister’s Questions that the “sprint” to decarbonise the electricity grid was more important to stop the UK from being over-reliant on international markets.
ING economist James Smith there remained a “distinct possibility” that a cut could come this month if tensions in the Middle East were to “rapidly de-escalate”.
