The Bank of England is anticipated to keep interest rates unchanged on Thursday, as the inflation threat appears less severe than feared and expectations for a resolution to Middle East conflicts have driven down energy costs. Currently, both traders and economists widely expect the central bank to maintain its key rate at 3.75%.

While the war in the Middle East has impacted the real economy, a new ceasefire agreement in the region this week and a sharp drop in oil prices have increased the likelihood that the inflation peak could be significantly lower than even the Bank's most optimistic forecast. Traders are still pricing in one 25-basis-point rate hike for this year, but many economists believe rates have already peaked.

A survey conducted from June 10th to 12th shows economists expect the Monetary Policy Committee (MPC) to vote 7-2 to hold rates. Chief Economist Huw Pill and external member Megan Greene are forecast to vote for a hike to prevent recent energy-driven inflation from becoming a persistent issue. Pill voted for a hike to 4% in April, while Greene has consistently expressed concern about the "second-round effects" of inflation on wages and prices, stating that "the case for raising rates has strengthened as the conflict has continued."

Regardless of their votes, both are likely to highlight the Bank's own survey showing UK households expect prices to rise by 4% over the next 12 months—double the Bank's 2% target. However, dovish officials are expected to remain in the majority, as concerns about weakening labor demand persist. These were the same factors that pushed the MPC towards considering rate cuts before the conflict began.

Deputy Governor for Monetary Policy Clare Lombardelli and member Catherine Mann are seen as potential hawks but are not expected to join Pill in calling for a hike this month.

UK Gilt Yields Retreat but Remain Above Pre-War Levels

Governor Andrew Bailey has described the current policy stance as "actively on hold," meaning that tighter financial conditions are doing the work of dampening demand in place of the central bank. With the Bank having ruled out rate cuts and markets still pricing in future hikes, the MPC has effectively achieved the equivalent of three 25-basis-point rate hikes since early February without actually raising the policy rate. Households and businesses are feeling the pressure through higher mortgage and credit costs.

However, market conditions have eased notably over the past week, which could ironically fuel fresh inflation concerns. Swap rates used by banks to set mortgage rates have fallen, while the 10-year UK gilt yield has dropped to a two-month low of 4.75%.

UK Inflation Peak May Be Lower Than Bank's Most Optimistic Forecast

In April, the MPC stated it would "continue to monitor closely the situation in the Middle East and how it transmits to the economy," adding it "stands ready to take action as needed to ensure CPI inflation returns to the 2% target in the medium term." Economists believe this language will likely be retained given the high uncertainty surrounding the Middle East and the economic outlook.

Policymakers May Favor a More Benign Inflation Scenario

Policymakers may use scenario analysis to illustrate a shift in their thinking. In April, the Bank presented three scenarios, all of which saw inflation staying above 3%. At that time, most members favored the middle Scenario B, which implied a need for higher interest rates. Now, with oil prices significantly below the levels assumed in all the Bank's models, policymakers may lean towards Scenario A, which assumes a short-lived and mild energy shock with no second-round inflation effects, requiring no further rate hikes.

Deputy Governor Dave Ramsden has said that if "some of the downside risks in Scenario A were to materialize, I would be inclined to support a more accommodative policy path." With improved geopolitical prospects in the Middle East triggering a sharp fall in energy prices, the UK's inflation peak is now expected to be well below the level forecast in the Bank's previously most optimistic scenario.

Based on current energy prices, UK inflation is projected to rise only modestly to around 3%. This is notably lower than the 3.6% peak later this year under the Bank's most optimistic April scenario and far below the over 6% peak in early 2027 under the worst-case scenario.

Economists Dan Hanson and Ana Andrade stated, "Marking oil and gas futures to market on June 16 suggests inflation will stay close to 3% over the next year." They added that if current trends in energy markets persist, it would give the Bank room to hold rates steady rather than hike in the coming months, which is their current baseline forecast.

Data released Wednesday showed UK inflation for May was 2.8%, below market expectations, increasing pressure on MPC hawks to reassess their stance. Although the UK's energy price cap is set to rise 13% in July, which will push inflation higher, a significant fall in oil prices could see lower petrol prices in the coming months offsetting some of that impact.

While traders are still pricing in one more hike, pressure for the Bank of England to ease policy again may re-emerge as the inflation outlook improves and the focus shifts to labor market weakness. Tomasz Wieladek, Chief European Economist at T. Rowe Price, said, "Given the real economy has already been hit, the next move is likely to be a cut."