As expected, the Monetary Policy Committee (MPC) voted unanimously to hold rates at 3.75% at its March meeting while it waits to get a clearer view of the fallout from the ongoing Iran conflict. The Monetary Policy Summary and Minutes also took a more hawkish shift from the MPC’s previous bias to easing to highlight the Middle East crisis’s upward impact on inflation. This move explains Thursday’s sharp rise in financial market rate expectations and gilt yields. That said, the MPC’s guidance also focused on the potential hit to demand in the medium term from the conflict.

Ultimately, this was a ‘wait and see’ meeting with the MPC pointing to the value in keeping rates on hold due to huge uncertainty around the outlook. The next move will depend on where energy prices go from here and whether there’s evidence of second-round effects. While the risks of a rate hike have risen, it’s far from guaranteed.

Second-round effects key to where MPC goes next

The MPC acknowledged that the Iran conflict had materially lifted the inflation outlook, but that the downside risks to growth had also increased, prompting the guidance to shift away from further easing to a more balanced view.

After February’s meeting, the MPC expected inflation to reach 2% in April and stay there. When the Committee met this month, it acknowledged that inflation could rise in Q3 to 3.5% based on energy futures curves from a few days ago. But, if Thursday morning’s energy prices are maintained, then we estimate inflation will rise to over 4%.

However, the MPC was clear that it can do little to stop the initial jump in energy prices. After all, the Bank of England (BoE) can print money, but it can’t produce oil. Instead, the focus is on second-round effects and the impact on inflation expectations.

Governor Andrew Bailey summed up the big worry here: “The recent experience of high inflation may also make households and businesses more sensitive to a new inflationary shock.” This would make businesses more likely to raise prices to offset higher costs and households try to bargain for higher wages to offset the hit to their real incomes. Both would push inflation higher and beyond the initial impact from energy prices and be a reason for the BoE to hike interest rates.

At the same time, however, the UK economy is starting from a weak position. The unemployment rate is at 5.2% and private sector wage growth is slowing sharply. This climate of lower demand will make it harder for firms to raise prices and give inflation-busting pay rises, making second-round effects less likely.

Ultimately, the MPC kept its options wide open at Thursday's meeting, making it clear that monetary policy could respond in either direction depending on how the conflict evolved. It warned that: “A larger or more protracted shock, which risked greater second-round effects in wage and price setting, would require a more restrictive policy stance.” However, if “the shock was very short-lived” or there was a hit to medium-term demand, then “policy would need to be less restrictive”.

This all suggests the outlook was too clouded for the BoE to move interest rates in March. It will instead wait for another six weeks, when it will have a clearer view of the potential impact on the economy.

UK inflation outlook is as clear as crude

While we emphasise that looking ahead is virtually impossible given that the outlook can change daily, our base case is currently for rates on hold for the rest of this year with the risks skewed towards rate hikes.

There are really four things that matter for the interest-rate outlook.

• How high energy prices go.
• How long they stay there for.
• If firms raise prices.
• The hit to demand.

If there’s a swift resolution that sees energy prices fall back sharply, then there’s still a chance of at least one rate cut later this year, probably in the summer. Admittedly, this situation seems increasingly unlikely following attacks on energy infrastructure, such as the bombing in Qatar this week of Ras Laffan, the world’s largest liquified natural gas plant. Repairing and restarting production would take time even if the hostilities end quickly.

In fact, if energy prices stay around Thursday’s levels, then inflation will peak at between 4−5% later this year. That’s a little higher than the BoE’s estimates, which are based on prices earlier this week. That would be enough to rule out cuts, but it doesn’t necessarily mean that the BoE will hike rates either. The weakness in the labour market and the hit to demand lessens the likelihood of second-round effects and means the bar to rate hikes is high.

The deciding factor will be whether there’s any evidence of second-round effects emerging. If there is evidence of firms passing on cost increases and inflation expectations are rising, then the BoE will be forced to raise interest rates.

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