Traders have sharply escalated their wagers on additional interest rate increases from the Bank of England, following a surge in energy prices linked to the Middle East conflict and emerging risks within the food supply chain that threaten to keep inflation stubbornly above the central bank's target. This comes just ahead of the BoE's latest monetary policy decision on Thursday.
Following the July policy meeting, Governor Andrew Bailey delivered an unusually candid message to reporters: "Please don't leave this room with the idea that the Bank of England is heading towards raising interest rates." However, he may find it difficult to maintain that conviction at Thursday's meeting. Unresolved tensions in the Middle East are exerting robust upward pressure on energy costs, with Brent crude consistently holding above $100 per barrel and natural gas prices posing a particular challenge for the UK. Bailey recently acknowledged to lawmakers that energy prices could potentially rise even higher.
New risks are also emerging that could keep inflation above the BoE's 2% objective throughout most of next year. Following a period of widespread drought and the impending effects of a powerful El Niño weather pattern, food cost risks are beginning to surface. Other components of the consumer basket, including airfares, also remain problematic. Furthermore, the economy's rapid growth indicates that demand is proving stronger than anticipated.
Hetal Mehta, chief economist at St James's Place, described a scenario where "In a sense, energy prices are handing over the baton to food prices. The broader El Niño effect is likely to make inflation stickier next year. Even if the Middle East-related energy price inflation were to recede, you would then have another wave of food price increases on top of that – meaning the overall figure wouldn't fall back significantly."
Market Pricing for Rate Hikes Intensifies
Market adjustments have followed the heightened inflation risks. In the days subsequent to Bailey's July press conference, traders priced in less than a full 25 basis points of tightening by year-end. By September 11, however, they had priced in 46 basis points of hikes for the remainder of the year, along with bets for up to four increases by mid-summer.
A majority of BoE officials contend that a softening labor market and anticipated growth slowdown in the second half of this year will help contain the price pressures originating from the Middle East conflict. While July's GDP data suggests economic resilience, the overall evidence supports the view that second-round effects remain manageable. There are currently few signs that inflation is becoming entrenched. An August BoE survey on inflation expectations released last Friday indicated that expectations for the coming year had declined to 3.2% from 4% in May, while expectations for the period beyond the next 12 months fell to 2.9% from 3.5% in May.
Agency surveys conducted by the BoE among businesses found that wage agreements for 2027 were "broadly the same or lower" than those for 2026, which averaged 3.6%. A key domestic unknown is whether the UK's strong growth from the first half of the year can be sustained, or even prompt companies to resume hiring. Although forecasters expect rising inflationary pressures to weigh on consumers and economic activity, surveys indicate a boost in consumer and business confidence since Andy Burnham took office as Prime Minister in July, potentially adding to demand within the economy.
Energy Bills Are Set to Push Inflation Higher Again
Nevertheless, the central bank may have to alter its strategy at some point. Oxford Economics estimates that UK inflation, which currently stands at 2.9%, could rise to near 4% around the turn of the year. This would be double the BoE's target and above the level where the central bank believes households begin to notice accelerating price increases. A key driver will be the UK energy price cap, which restricts the unit cost suppliers can charge consumers. The regulator Ofgem has announced the cap will hit a three-year high in October, with experts suggesting it could climb further in early 2027.
Andrew Goodwin, chief UK economist at Oxford Economics, noted, "We think the impact of the Middle East conflict is still building. We think the price cap could rise again by 13% in January. Current wholesale prices are significantly higher than during the previous observation window." The food industry is also cautioning that a combination of higher energy costs, impact from hot weather on harvests, and El Niño effects will push grocery spending higher for most of next year. The Food and Drink Federation expects food inflation to jump to nearly 4% before Christmas and reach a peak of 6.4% by July 2027.
Liliana Danila, chief economist at the FDF, identified the primary risk as "what happens with commodities and then what the knock-on effect will be from El Niño." She noted that crops including cocoa, coffee, palm oil, rice, and sugar could be affected, adding "we could see worse than expected... although so far we haven't seen the real impact on the ground yet."
UK Food Inflation Poised for Highest Since Early 2024
Most economists expect the BoE's Monetary Policy Committee to vote 6-3 on Thursday to hold rates at 3.75%. Matt Swannell, chief economic advisor at the ITEM Club, suggested the committee would likely "sound hawkish in its rhetoric to show it's prepared to fight inflation, to avoid any unnecessary loosening of financial conditions." Additionally, the MPC is widely expected to slow the pace of reduction in its government bond portfolio to account for fragility in the bond market. Since the start of quantitative tightening in 2022, the BoE's bond holdings have been trimmed from £875 billion to £489 billion. The market anticipates the bank will ease the reduction pace from £70 billion over the previous 12 months to £50 billion over the 12 months starting in October.