Geopolitics were always going to be a risk factor this year and the weekend’s deepening hostilities in the Middle East underline that point. Hundreds of people have been killed in Iran, with further fatalities reported in Israel and among US armed forces personnel. While Iran has said it will not block the Strait of Hormuz, a critical route for global oil shipments, the escalation is already adding fresh volatility to global energy markets. These tensions are likely to shape price movements over the coming days, if not weeks. For UK firms and households, this could feed through into inflation and therefore interest rate decisions this year.

Counting the cost of higher energy prices

The primary way events in Iran will impact the UK economy would be through energy prices. The immediate and most direct effect is the jump in global oil prices to $80. The ultimate outcome will depend on how high oil prices go and for how long they stay there.

A rule of thumb is that a $10pb rise in oil prices adds about 0.1ppts to inflation in the following months as fuel prices move higher. It eventually adds another 0.1ppt as higher transport costs work their way through supply chains. So, the roughly $10 rise since Friday morning could add 0.2ppts to inflation this year.

However, it’s critical to note that the potential for economic damage and lasting inflation is smaller than it’s been in the past. The price of oil following the second Gulf War in 2003, for example, averaged $75.93 for Brent crude, the global benchmark, while West Texas Intermediate (WTI), the North American benchmark, averaged $72.80.

Today’s prices are not far off: Brent crude currently sits at $79.36, while WTI was $72.52. Adjusted for inflation from 2003-13, that would imply a current price above $100. So, oil today is in real terms cheaper, even with the recent 30% increase in Brent crude since December.

For the UK, though, oil is not the only issue. The UK imports 50−60% of its natural gas, with 20−25% of UK natural gas coming from liquefied natural gas (LNG), a large share from Qatar. Indeed, we saw the impact that soaring natural gas prices can have on the UK when Russia invaded Ukraine. If supplies of LNG are disrupted, then we could see a significant rise in gas and electricity prices, since gas prices still tend to be the marginal setter of electricity prices.

Since natural gas and electricity make up about 3% of the CPI basket, a sustained 10% rise in energy prices would add an additional 0.3ppts to inflation.

What conflict could mean for UK interest rates

The good news is that UK inflation has already dropped to 3% and was heading to 2% in April as friendly base effects and policy measures announced in the Autumn Budget weighed on inflation. The bad news is that a rise in energy prices may offset some of that positive downward trend.

At the time of writing, UK natural gas futures have risen by around 50% since Friday. That would directly add around 1.6ppts to headline inflation through higher household utility bills and potentially even more as firms pass on increased production costs to consumers. But, because of the energy price cap, movements in wholesale energy prices feed into bills with a lag. That means the impact of higher wholesale gas prices wouldn’t be felt until July at the earliest. The impact of higher oil prices would be felt much quicker. Ultimately, it depends on how high oil and natural gas prices go and how long they stay there for.

For the Bank of England (BoE), such a shock would be a balancing act. Traditionally, we would expect the Bank to ‘look through’ any jump in inflation due to volatile global energy prices. But, with inflation expectations still high and memories of the Russia-Ukraine crisis still relatively fresh, the BoE may not feel like it has that luxury now.

Indeed, surging energy costs will shift the focus of the MPC’s meeting this month from what was a certain rate cut to a live meeting, especially since energy prices are one of the most important factors for households’ inflation expectations. If energy prices are still rising at the time of the MPC meeting on 19 March, then the BoE may prefer to keep rates on hold until April when it’ll have more certainty about the energy price outlook.

The bottom line is that surging energy prices risk boosting headline inflation, at least relative to previous expectations, and complicating the BoE’s path. Short shocks imply temporary inflation blips and limited policy moves. However, prolonged disruption risks material upward pressure on the CPI and a renewed case for tightening by the MPC, with knock-on costs for borrowing, mortgages and growth.

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