Bank of England holds interest rates at 3.75% as inflation fears mount

The Bank of England has kept UK interest rates on hold as it warned that a further escalation in the Iran war could drive inflation above 4% next year, adding to cost of living pressures on households.

Against a volatile backdrop in the Middle East conflict, the Bank’s monetary policy committee (MPC) voted by six to three to keep its key base rate at the current level of 3.75%.

As Donald Trump’s renewed attacks on Iran drive up global energy prices, the Bank warned that an “adverse scenario” involving a drawn-out war and oil prices remaining above $100 a barrel could drive UK inflation to a peak of 4.5% by the middle of 2027.

Brent crude, the international benchmark, briefly rose above that level last week before falling back, amid fears that the violence across the region could shatter the world economy’s earlier resilience to the war. The oil price was trading above $90 a barrel on Thursday.

In a decision taken after UK inflation dropped by more than expected in June, Threadneedle Street said there were signs the impact from the war could still be contained because Britain faced a sluggish growth outlook and rising levels of unemployment.

Andrew Bailey, the Bank’s governor, said: “Inflation has fallen faster than we’d expected, but the conflict in the Middle East continues to mean high and volatile energy prices. That will cause inflation to rise again later this year. However the conflict unfolds, our job is to make sure any increase in inflation is temporary and that it comes back to our 2% target.”

Publishing its central forecast, involving the oil price falling back to about $71 a barrel, Threadneedle Street said it still expected inflation in the UK to a peak at about 3.2% later this year as households come under pressure from higher fuel and energy prices.

The interest rate decision comes as Andy Burnham pushes to lower the cost of living after announcing a sweeping package of support for households and businesses in his first week as prime minister.

Under his plans, electricity bills in Great Britain will be cut by an average of £45 a year from October, after he said the government would remove VAT from them. The Bank expects the policy, alongside a £2 cap on bus fares, to reduce the headline inflation rate by 0.1 percentage point.

Official figures show inflation in the UK fell by more than expected in June to 2.6%, from a peak of 3.8% last year. It had been on track to fall close to 2% before the outbreak of the Iran war.

The Bank said a loose labour market and higher borrowing costs for households and businesses compared with before the Iran war would reduce inflation over time, with conditions before the conflict more “benign” than they were before previous global shocks, including the Covid pandemic and Russia’s 2022 invasion of Ukraine.

However, the MPC said it “stands ready to act as necessary” to prevent inflationary pressures from becoming entrenched.

Highlighting the risk of stubbornly high inflation, Catherine Mann, an external economist on the MPC, joined her fellow committee members Megan Greene and Huw Pill in dissenting against the majority of the panel with a vote to raise rates immediately to 4%.

Greene, another external member, and Pill, the Bank’s chief economist, had previously been outvoted in pushing for a quarter-point rise at the last MPC meeting amid concern about inflation.

Financial markets had priced in a more than 90% probability of Threadneedle Street keeping borrowing costs on hold, with the outside chance of a rise. Investors expect a rise in borrowing costs to 4% before the end of the year.

The news comes after the US Federal Reserve held borrowing costs unchanged on Wednesday and its new chair, Kevin Warsh, unnerved some investors worried over its readiness to tackle high inflation.

After a press conference that analysts said was light on detail, US borrowing costs rose to the highest level since 2007 amid concern the Fed would not be able to contain the energy price shock from the Iran war.