Economists are questioning whether the Bank of England would need to embark on a significant hiking cycle following its decision to hold rates at 3.75% and warn of potential rate increases driven by the Iran war’s energy price impact. The monetary policy committee voted unanimously to hold on Thursday, but the hawkish signals about potential rate increases have prompted debate about the appropriate scale and speed of any tightening response to what is fundamentally an external, supply-side shock. Officials warned that inflation could rise above 3% but acknowledged the domestic economy was also softening.
The debate among economists centres on the appropriate monetary policy response to a supply-side inflation shock. When inflation is driven by demand — too much spending chasing too few goods — raising interest rates is a direct and effective remedy. When inflation is driven by supply — in this case, a war disrupting energy production — rate hikes can dampen inflation but at the cost of reducing economic output and employment in an already weakening economy.
Governor Andrew Bailey appeared to acknowledge this tension in his communications, cautioning against the assumption that significant rate hikes were inevitable. He said the Bank would respond if inflation became entrenched but suggested that the appropriate response would depend on the persistence of the shock. His language implied that a limited and targeted tightening, rather than an aggressive hiking cycle, was the most likely response if action were needed.
Financial markets are pricing in two quarter-point hikes before year end, a relatively modest tightening by historical standards. Analysts noted that the Bank would need to balance the risk of acting too aggressively against a supply-side shock with the risk of acting too timidly and allowing inflation expectations to become unanchored. Getting that balance right will be the central challenge of UK monetary policy in 2025.
For UK borrowers and businesses, the pace and scale of any hiking cycle will determine the practical financial impact of the Bank’s response. Two quarter-point increases to 4.25% would be meaningful but not dramatic. A larger cycle — if the conflict escalates and energy prices rise further — could be significantly more damaging to household finances and economic activity.