The Bank of England has been forced into the most difficult inflation call in years following the outbreak of the Iran war, voting unanimously to hold rates at 3.75% on Thursday while trying to assess whether a geopolitically driven energy price shock warrants a rate hiking response in an economy already showing clear signs of weakness. The monetary policy committee described the war as a significant new shock that had created a policy environment where the conventional response to rising inflation — tightening monetary policy — carries unusually high costs in terms of foregone growth and rising unemployment. Officials warned that the conflict could push inflation above 3% and require rate increases.
The difficulty of the inflation call lies in the supply-side nature of the shock. Conventional demand-side inflation responds well to rate hikes because higher borrowing costs directly reduce the spending that is driving prices up. Supply-side inflation from an energy price shock is harder to address through rate hikes because the shock originates in global markets rather than in domestic demand. Raising rates can dampen the second-round effects of the energy shock, such as higher wage demands and broader price increases, but cannot address the primary shock itself.
Governor Andrew Bailey acknowledged the difficulty of the call without explicitly resolving it. He said the Bank was assessing whether the energy price shock was likely to generate significant second-round effects — the kind that would justify a rate hike response — or whether it would prove temporary and self-correcting. His communication reflected the genuine analytical difficulty of making that assessment in real time.
Financial markets made a simpler call. UK gilt yields rose, the FTSE 100 fell, and the pound strengthened against the dollar as traders priced in rate hikes before year end, applying a relatively conventional inflation-fighting framework to an unconventional supply-side shock. Analysts noted that the market’s call might prove correct even if the reasoning was less sophisticated than the Bank’s more nuanced analysis.
For the Bank, the most difficult inflation call in years will ultimately be resolved by the data. If the energy price shock proves temporary and second-round effects remain limited, the call to hold will be vindicated. If the shock proves persistent and broader inflation pressures build, the case for rate hikes will become compelling. The Iran war has forced the Bank into a genuine analytical challenge where the right answer depends on outcomes that are, as yet, unknowable.