As expected, the Monetary Policy Committee (MPC) left interest rates unchanged at 3.75% in July. While the 6-3 vote split was more hawkish than anticipated, the overall message was relatively dovish, with policymakers taking comfort from weaker inflation and limited evidence of significant second-round effects from higher energy prices. However, the outlook remains highly dependent on energy markets. If gas and oil prices rise further, rate hikes remain a possibility. If prices remain around current levels, the Committee is likely to keep rates on hold this year before resuming cuts in 2027.

Hawkish vote, but dovish forecasts

As expected, the MPC left rates unchanged in July, although the 6-3 vote split was slightly tighter than anticipated. With the hawks arguing that five years of above-target inflation may have partially de-anchored inflation expectations, increasing the risk that firms pass on higher costs and workers push for stronger pay growth. In their view, precautionary rate rise would help prevent inflation becoming embedded.

However, the broader message was more dovish. The Committee took comfort from the underlying disinflationary trend, stating that “all members acknowledged that there had been sustained disinflation pre-conflict”. Indeed, direct energy effects have added 0.7 percentage points to inflation relative to the Bank’s February projection, suggesting inflation would have been at target if not for the conflict in the Middle East.

For now, the MPC also appeared relatively confident that second-round effects will remain limited. Policymakers noted that there had been little evidence of these materialising and that a weaker labour market should help contain inflation pressures. Nevertheless, ‘second-round effects’ were mentioned 35 times in the minutes and the Committee agreed that they were the key uncertainty surrounding the appropriate policy response.

All told, the MPC was never likely to hike rates at the meeting. Inflation has eased materially since the last meeting and there is little evidence of stronger wage or price setting behaviour yet.

Re-escalating tensions will keep MPC wary, risks skewed to hikes

Looking ahead, our base case is still for interest rates to keep rates steady for the rest of the year.

Crucially, the disinflation trend remains intact. The Bank’s measure of underlying services inflation fell to 3.8% in June, its lowest level since February 2022. A weaker labour market has helped cool pay growth to target-consistent levels, reducing the risk of second-round effects.

Furthermore, at 3.75%, interest rates are already restrictive enough to bring inflation back to target. The jump in market interest rates has also pushed up borrowing costs in the real economy, meaning markets have already done much of the MPC's work.

However, the risks are clearly skewed towards rate hikes later this year. Governor Bailey highlighted that “repeated resumptions of conflict, combined with lower than usual European gas stock levels and a fall in global refining output” could all push global energy prices higher, forcing the MPC to hike rates.

At the same time, a fiscal loosening at the next Budget would boost demand and in turn inflation, increasing the likelihood of rate hikes. Even so, any tightening cycle would probably be much smaller than that seen in 2022-23 given weaker growth and softer labour market conditions.

Ultimately, whether there are rate hikes this year hinges on the conflict in Iran and how energy prices respond. Our base case is for rates to remain on hold for the rest of this year before cuts resume in 2027 but another sharp rise in energy prices could still force the MPC to tighten policy in the second half of the year.

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