How patient can the Bank of England be?
Will policymakers be forced into an unexpected rate hike? Investec Chief Economist Philip Shaw explains how energy prices, wages and inflation expectations will shape the Bank of England’s next move – and reveals what he expects to happen.
The Monetary Policy Committee (MPC) kept the Bank rate at 3.75 per cent this month, in line with general expectations. But the decision was less comfortable than the unchanged rate suggests. The committee voted 6–3 to hold, with committee member Catherine Mann joining Huw Pill and Megan Greene in backing a 25bp increase. That was one more dissenter than in June – and a clear reminder that the next move for rates is no longer automatically assumed to be down.
At the heart of the debate were ‘second-round’ inflation effects: the risk that the rise in energy prices triggered by the US–Iran conflict feeds into wage settlements and, ultimately, broader domestic price pressures. On the evidence so far, the news is reassuring. Members broadly agreed that substantial disinflation had taken place before the conflict and that there were few signs of an inflation–wage feedback loop emerging. The disagreement is over how long that reassurance can be trusted.
For the majority, a subdued economy, spare capacity in the labour market and the tightening in financial conditions since military action began should restrain wage growth. These forces provide some insurance against renewed, broad-based inflation pressures and allow the MPC to wait for clearer evidence rather than tightening pre-emptively. There is also a plausible route to a more benign outcome: a lasting ceasefire between Washington and Tehran could pull global energy prices lower and remove much of the immediate threat.
The hawks see the balance of risks differently. Inflation has been above the 2 per cent target almost continuously for five years. Against that backdrop, firms and workers may be quicker to respond to another rise in headline inflation than standard economic models suggest. Mann, Pill and Greene therefore favour a risk-management approach. A modest increase now could limit the need for larger rises later if pay rates do in fact accelerate. If the feared wage response fails to materialise, the tightening could be reversed.
Why timing matters more than ever
That argument is not without its merits. Waiting provides more information, but it also gives any second-round effects time to take root. Once higher inflation becomes embedded in pay settlements and companies’ pricing decisions, returning it to target may require a more prolonged squeeze on demand. The MPC is therefore weighing the cost of perhaps tightening unnecessarily against the potentially greater cost of acting too late.
The accompanying Monetary Policy Report puts numbers around that dilemma. Having relied entirely on scenarios in April, without specifying a baseline, the Bank has restored a central projection alongside ‘milder’ and ‘adverse’ alternatives. Each is constructed based on the Bank rate evolving as markets currently price in—broadly two 25bp increases by mid-2027, followed by unchanged rates.
In the central projection, higher energy prices lift inflation in the near term and generate moderate second-round effects, but inflation falls to 1.9 per cent after three years. In the milder scenario, energy prices are somewhat lower and second-round effects do not emerge; inflation ends the forecast at 1.7 per cent. The adverse case is more troubling. With a less favourable combination of energy prices and pay pressures, inflation remains above target at 2.4 per cent at the three-year horizon.
The point of these projections is not simply to set out forecasts within three scenarios. Rather they show what matters for policy: how long the energy shock lasts and how wages respond. The first is largely beyond the MPC’s control; the second will determine whether the shock remains a one-off change in the price level or develops into persistent inflation. Governor Andrew Bailey played down that there are now more MPC members who voted for a hike, firmly rejecting the suggestion that the committee was ‘edging towards a rate hike’. We agree—up to a point. Our best guess remains that the Bank rate will stay at 3.75 per cent through this year. Weak growth, a loose labour market and the absence of second-round effects should allow the majority to hold its nerve.
But this has become more of a conditional call, not a comfortable one. The longer Gulf tensions keep energy prices elevated, the greater the chance that workers seek compensation through higher pay and the more difficult it becomes for the MPC to wait. At some point, concerns about inflation persistence—and about the Bank’s credibility if it fails to respond—would outweigh the case for patience.
For now, the MPC can hold fire. But the clock is ticking: no hike remains the most likely outcome this year, while the risk of a reluctant increase is moving steadily higher.