The news of progress towards a deal between the US and Iran and the eventual reopening of the Straits of Hormuz has sent oil prices plummeting from around $110 per barrel (pb) to just over $90pb. Admittedly, it feels like we’ve been here several times already (in fact, I think I’ve written that exact line before), only for a deal to fall apart and oil prices to shoot back up. However, if oil prices remain around current levels the economic damage should be limited to a case of mild-stagflation and the Bank of England (BoE) will be able to keep interest rates on hold this year. That should prevent house prices continuing to decline as they did in May, but it will still be next year before we see any real momentum in the housing market.

Interest rate hike off the table this month, but little chance of a return to rate cuts

The drop in oil prices from about $110pb a week ago to around $95pb today, assuming it’s maintained, means inflation will probably now peak at the lower end of our 3.5% to 4% estimate in Q4 of this year. That’s good news for everyone, but especially the BoE. Afterall, the Bank knows that it can’t do anything to bring down oil prices, so what it’s really concerned about is the initial spike in inflation leading to second-round effects. That’s where employees bargain for inflation busting pay rises and firms pass on the increase in costs to their customers and it turns what should be a temporary increase in inflation into a much more serious issue, as happened in 2022. A smaller initial shock significantly reduces the chances of those second-round effects emerging.

The drop in oil prices also increases the chances that consumers will see this as a temporary shock to their incomes that they can smooth through by reducing saving, rather than heavily cutting back on spending. Most importantly, an impending end to the conflict significantly increases the chances that the BoE will treat this as a temporary spike in inflation that will unwind by itself without the Bank needing to raise interest rates to intervene. Indeed, the chances of a rate cut later this month have fallen to just 6%.

However, there is little chance of returning to the pre-crisis world where we were expecting the Bank to cut interest rates two or three times this year. Inflation will still rise significantly, and inflation expectations are drifting upwards as we enter the fifth consecutive year of above-target inflation.

So even though the BoE base rate is set to remain at 3.75%, the rate curve has shifted upwards. What’s more, gilt yields, which set the cost of borrowing for much of the economy, are about 60bps higher than they were in February, before the Iran war. That will keep borrowing costs elevated for firms and mortgage holders.

House price momentum to remain subdued this year

Most of the data this week will focus on the housing market, which has so far avoided a knee-jerk reaction to the Iran crisis. Mortgage approvals have remained steady and survey measures of house prices have continued to rise through March and April.

However, much of this data relates to transactions agreed before the war in Iran and subsequent jump in the rate curve. More recent survey data, such as the RICS, suggests approvals, transaction and price growth will all slow sharply in the coming months. Indeed, this morning’s Nationwide data suggested house prices dropped by 0.6% in May. That’s to be expected given the recent period of huge volatility. It would be a miracle if the housing market wasn’t impacted.

The drop in oil prices should help bring some normality back to the mortgage market, especially if the BoE takes a relatively measured view on the outlook for interest rates at its next meeting later this month. Indeed, the housing market proved itself nothing if not resilient through Covid and the various budgets over the last few years. But momentum in the housing market is weaker coming into this crisis than in 2022. The combination of higher stamp duty, the new ‘mansion tax’, increasing worries about job security and now potential worries about new taxes, should we get a new Prime Minister and Chancellor, will conspire to keep momentum subdued this year. We doubt there will be much positive news on house prices until 2027, when the Bank should start cutting interest rates, particularly with real wages, often the underlying driver of house prices, stagnating.

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