If you have the bad luck to be in the middle of a remortgage or a refinancing round right now, you’ll already be seeing the impact of higher interest rate expectations in response to increased energy prices. The ‘good’ news is that the bar to rate hikes is probably higher now than it was in 2022. So, we’re more likely to see a period of rates on hold rather than a rapid rise. But, without a swift resolution to the conflict in Iran and the Middle East, the two rate cuts we were hoping for this year, and lower gilt yields, look unlikely. This will deepen the hit to the economy from higher energy prices.

How could the BoE respond to the energy price shock?

Energy price shocks are every central banker’s worst nightmare. They’re particularly difficult to deal with because they simultaneously push up prices and depress demand.

If the Bank of England (BoE) cuts interest rates to support demand, then it risks inflation rising faster. But, if it lifts rates to dampen inflation, that depresses the economy even further, potentially also leading to inflation undershooting its target in the future.

What’s more, energy prices are particularly tricky to deal with because they are a supply-side shock. This means increasing interest rates won’t do anything to bring down oil prices. After all, the BoE can print money, but it can’t produce oil.

The economics textbook response to these energy-price movements is for the BoE to ‘look through’ (ignore) the energy price shock. That’s because their impact on inflation would only last a year, after which they’d drop out of the annual comparisons. Meanwhile, it takes two−three years for interest-rate changes to fully impact the economy. The BoE would therefore usually be expected to focus instead on the negative impact on demand in the medium term. It's why the BoE was very reluctant to raise interest rates at the start of the crisis in 2022 when Russia invaded Ukraine. So, score one for proactively cutting interest rates.

However, the BoE may not feel like it has the luxury of just looking through this energy price shock. That’s because inflation has been above the 2% target now for almost five years and inflation expectations are still above normal levels. Given the cost-of-living crisis still looms large in memories, households and businesses are especially sensitive to inflation at the moment. So, a score against proactively raising interest rates.

Managing second-round effects

The more sensitive people are to inflation, then the more likely there is to be second-round effects. This is where businesses pass on cost increases, so we see prices rise in goods and services across the economy, not just in fuel and energy. At the same time, employees bargain for higher wages to offset the hit to their living standards from higher prices.

The BoE may not be able to do anything about the initial rise in energy prices. However, it can try to prevent those second-round effects from emerging by increasing interest rates to dampen demand and prevent firms from passing on price increases. Score one for proactively raising interest rates, so far making two scores for an interest-rate rise against one for a cut.

Yet, the UK economy is in a radically different state now to what it was in 2022. The risk of second-round effects is much smaller now. The labour market is much weaker. The UK unemployment rate is at 5.2% compared to 3.8% in 2022. Private sector wage growth has also slowed sharply. This will make it harder for employees to protect real pay. We know that labour market weakness has been a focus of concern for at least four Monetary Policy Committee (MPC) members. An energy-price shock is only likely to make the employment outlook worse.

What’s more, monetary policy is much tighter now. Interest rates at 3.75% are still probably in restrictive territory compared to just 0.5% in 2022. This means there’s less need to raise them quickly. Fiscal policy will also probably be less accommodating now than it was in 2022, when the government offered a support package worth around £80bn. Score one against proactively raising interest rates to make the balance between these two options level.

What will the BoE do on Thursday?

Given the impossible-to-predict outlook, the most sensible, and likely, response for the BoE is just to sit tight. That may feel frustrating: a crisis surely demands action! But, arguably the UK has had a little too much policy action of late. Some stability is what is needed.

The BoE can then take action later this year if it needs to support the economy or clamp down on rising second-round effects. One other factor is that gilt yields have surged from about 4.25% before the crisis to 4.75% now. That will raise borrowing costs through the economy and help dampen second-round effects without the BoE having to do anything.

So, the base case has changed from a nailed-on rate cut this week and one more in the summer, to the rates staying at 3.75% throughout the year. Obviously, that depends on what happens to energy prices. But, the bar to rate hikes now is much higher than it was in 2022.

Labour market weakened heading into energy-price shock

UK jobs data this week for January and February will continue to paint a picture of a loosening labour market.

The unemployment rate will probably hold at 5.2%, although the Labour Force Survey continues to distort the headline employment figures. UK economic growth disappointed in January, which means the risks are clearly skewed to a further rise to 5.3%.

Meanwhile, private sector pay growth is likely to tick up to 3.5% from 3.4%, but that will be driven by an usually weak reading this time last year dropping out of the annual comparison. The bigger picture is that wage growth continues to ease and that will be evident in whole economy pay growth, which should slide to 3.9% from 4.2% as more favourable base effects weigh on public sector pay.

Unlike when Russia invaded Ukraine, the labour market is now far weaker so this will be a key consideration for the MPC as it assesses how it should respond to higher energy prices. A weak jobs market is one reason we think a prolonged hold is more likely than a hike this year, especially if energy prices remain around current levels.

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