The Monetary Policy has changed its mindset. What’s next for interest rates?
Investec Chief Economist Philip Shaw explains why an interest rate rise now looks more likely – and when these changes are expected.
The Bank of England’s Monetary Policy Committee voted 6-3 to keep the Bank rate at 3.75% earlier this month, with the three dissenters backing a quarter-point increase. This was exactly the same voting pattern as in July 2026. Yet the meeting appeared to mark a change in the committee’s collective thinking about the possible need for higher rates. Four members who backed unchanged policy, including Governor Andrew Bailey, acknowledged that upside risks to inflation had increased since the summer. They also seemed less certain that rates should remain on hold.
Interest rate changes affect economic activity and inflation with a lag, building to their total effect over two to three years. There is no magic lever the MPC can pull to bring CPI inflation, currently 3.1%, back to its 2% target in the near term. It is the committee’s concerns over the medium-term outlook which are relevant here. Two factors are becoming increasingly important.
First, the Iranian conflict is now seven months old. Energy prices have fluctuated since it began, but remain well above pre-crisis levels. For example, the Brent crude oil price has averaged about $95 a barrel, compared with $69 in February. Meanwhile, the current price is above $100. Every additional week of tension in the Middle East means not only higher prices at the petrol pump, but also higher energy costs for businesses. Many of those costs may be passed on to consumers, adding to broader inflationary pressures. In addition, a prolonged period of higher inflation could also trigger faster pay growth. That would risk a feedback loop, with firms in turn passing higher wage costs on to consumers. If this scenario materialised, the Bank would need to lean harder against a more entrenched inflation problem. The result would be greater economic volatility.
Second, the Bank’s baseline forecast in July’s Monetary Policy Report showed inflation returning to 2.0% by the first quarter of 2028. This is close to our own view, but it depends on energy prices falling. A further delay in the US and Iran reaching an agreement would keep CPI inflation elevated for longer. That would sit uneasily alongside the UK’s recent record. Apart from a brief three-month spell, inflation has remained above the 2.0% target for the past five years. Another prolonged overshoot could damage the MPC’s credibility. That would be serious at any time, but it matters even more now, given the nervous conditions currently entrenched in bond markets. A renewed inflation scare would push longer-term borrowing costs up further.
Against this backdrop of geopolitical uncertainty and fragile bond markets, an increase in the Bank rate at the MPC’s next meeting in early November now looks more likely. In addition, a second increase could well follow in February. These should be considered to be insurance hikes against even worse inflationary outcomes. If these do materialise, the committee can then tighten policy less aggressively than it would have needed to after delaying action. By contrast, if the conflict ends soon, the MPC can effectively cancel the insurance policy and interest rates could resume their downward path later next year.