Bank of England holds fire on rate rises as Middle East tensions linger

The Bank of England is in no rush to raise interest rates while the outcome of the Iran war remains uncertain and the UK's growth rate stays weak, according to its governor, Andrew Bailey. Borrowing costs are expected to stay at 3.75% during the summer months, Bailey signalled at a conference in Reykjavik organised by Iceland's central bank.

Bailey said the central bank would accept inflation staying above its 2% target during the current crisis. This approach changes only if prices begin to rise permanently. "Given the context of softness in the real economy and uncertainty around the scale and duration of the shock, tolerating temporarily above-target inflation to provide some support for the real economy is an appropriate way to approach the trade-off [between inflation and activity]," Bailey said. "But that tolerance would weaken if signs of second-round effects begin to emerge."

At the start of 2024, financial markets had expected the Bank to cut interest rates twice during the year, bringing them down to 3.25%. Since the Iran war began, expectations have reversed entirely. Analysts now forecast a rate rise of 0.25 percentage points to 4% before December.

Central banks worldwide are struggling with shock increases in energy costs triggered by the conflict. The Federal Reserve, previously expected to cut rates under pressure from US president Donald Trump, is now forecast to hold them steady after Kevin Warsh took over as Fed chair on 22 May. Policymakers at the European Central Bank have signalled a likely rate rise in June after cutting rates more sharply than the Bank of England before the Middle East conflict.

Bailey explained that borrowing costs have already risen for homeowners and businesses without the central bank adjusting its rates. Mortgage costs have increased since hostilities began, as lenders abandoned expectations of rate cuts. Swap rates—financial hedging instruments that influence mortgage lending—have risen over the past month, reflecting predictions of upward rate movements. "We have, in effect, tightened policy in my view," Bailey said. "I was quite clear that I thought we probably would cut rates once or twice this year. That's off the table." The cost of new five-year fixed-rate mortgages has risen by about 1 percentage point, he added.

Hedge funds and other financial institutions that lend to businesses have also lifted borrowing rates. Many hedge funds, which are large bond buyers, had overestimated the likelihood of interest rate cuts, Bailey said. Their sudden shift in stance created exaggerated market swings. Rising bond rates have also increased the cost of financing the government's £3tn debt, though Bailey noted this trend has eased in recent weeks.

Bailey said the central bank is now better equipped to assess the impact of rising energy costs, having adopted scenario planning. The Bank now highlights the range of factors that could turn temporary inflation into something permanent. This means it is unlikely to allow a repeat of the 2022 inflation spike—which followed Russia's invasion of Ukraine and pushed inflation into double figures—without acting quickly, he said. "We have to monitor the situation in the Middle East and how it affects the UK economy and inflation very closely and adjust policy as required," Bailey concluded.