The Bank of England is unlikely to raise interest rates at its meeting on 17 September. In fact, holding rates at 3.75% looks like a decent bet, with financial markets giving a rate hike on Thursday odds of just 20%. However, the language accompanying the decision is likely to be much tougher than in July.

That means that while there may be no immediate action, the direction of travel is becoming less comfortable for businesses. Rising energy prices are increasing the risk that the Bank may need to tighten policy later this year, just as those same higher energy price raise input costs and dent demand.

Bank of England keeps interest rates in “wait and see” mode

The Monetary Policy Committee (MPC) has been remarkably patient over the past year, looking through higher inflation on the basis that it was largely driven by external factors, like higher oil prices, rather than excessive domestic demand. Afterall, the Bank can print money, but it can’t produce more oil.

That matters because central bankers are not in the business of reacting to every jump in oil prices. If they were, monetary policy would look a bit like a labrador chasing tennis balls (I have greyhounds, which are too lazy for fetch). Instead, the Bank wants to know whether higher energy prices are becoming embedded in wages, pricing decisions and inflation expectations before it responds.

There are still good reasons for caution, though. The labour market continues to soften, wage growth is easing and there is little evidence that inflation is becoming embedded across the economy. Higher gilt yields have also increased borrowing costs, meaning financial conditions have already tightened without the Bank needing to act.

In other words, the Bank can afford to sit on its hands for now.

Rising energy prices and inflation: the outlook for businesses

The challenge is that energy prices have started moving sharply higher again. Oil prices have climbed back above $100 per barrel and gas prices have risen significantly since the summer. That is likely to push inflation higher over the coming months and could see inflation approach 4% in early 2027.

For businesses, the immediate impact is obvious: higher operating costs.

Energy-intensive firms will feel the pressure first, but few sectors are completely insulated. Rising transport, logistics and input costs will eventually work their way through supply chains. However, there is also pressure on the revenue side. Households facing higher petrol and energy bills have less money available for discretionary spending. Businesses facing greater uncertainty may delay investment decisions. That combination of rising costs and weaker demand is rarely a recipe for strong profit growth.

What could force an interest rate rise?

The Bank is unlikely to react solely to higher oil and gas prices, unless they move even higher. Instead, it will be watching for so-called second-round effects. In plain English, that means checking whether workers start demanding larger pay rises, businesses feel more confident about raising prices, and inflation expectations begin drifting upwards.

So far, there is limited evidence that this is happening. Surveys suggest inflation expectations and expected wage growth remain relatively well behaved. But these effects tend to emerge slowly so an absence of evidence today does not mean they will not emerge later.

If energy prices remain elevated through the autumn, a rate increase at a later meeting, particularly in November, becomes a much more realistic possibility.

What the Bank of England’s September decision means for businesses

September should deliver a hawkish hold rather than an outright rate increase. However, businesses should not mistake a pause for an all-clear signal. The combination of rising energy costs and subdued demand creates a more difficult operating environment over the coming months. Rising interest rates would make that environment even more challenging.

The UK economy might finally have some much-needed momentum.

Growth smashed expectations in July coming in at 0.4% after already rising 0.3% in June. This was driven by strong IT and administrative services output. What’s more, there’s some evidence that IT activity is being underpinned by AI-related demand and cloud computing which suggests that momentum can continue.

Reassuringly, growth is being driven by private sector firms. We estimate the real economy has grown 2% in the past year, the strongest since 2022 when the economy was still recovering from the pandemic.

That’s even more impressive given the sharp rise in energy prices that have pushed inflation and dragged on real incomes since the start of the Iran war. In fact, all the evidence suggests that consumers and firms, at least so far, have been unfazed by higher inflation and persistent uncertainty.

In the near-term, that momentum should continue as consumer confidence rose a two-year high in August and business surveys point to solid growth. Even if business services give back some of July's gains in August, strong growth in July means we now expect GDP growth of 0.4% in Q3, up from 0.2% previously.

The labour market probably weakened further through the summer as uncertainty created by the war in the Middle East and the prospect of another tax-raising Budget begins to drag on hiring.

We expect the unemployment rate to tick up from 4.9% to 5.0% in July. Weak vacancies and employment surveys suggest that the unemployment rate will continue to trend up over the rest of the year, peaking at around 5.3%.

We expect private sector regular pay excluding bonuses to tick up from 2.8% to 2.9%, meaning that private sector pay is only just keeping pace with inflation and real pay growth probably become negative later this year. That will only pile on the pressure for the government to take action on the cost of living in the Budget.

For the MPC, a weak labour market and pay growth below the 3.25% level that the Committee estimates is consistent with at-target inflation will reassure most rate setters that they can remain on hold through the second half of the year even as inflation rises back over 3.5%.

That said, business surveys suggest that pay growth is likely to pick up and the labour market should recover across 2027 which will allow wages to catch up with inflation and lift private sector pay from 3.0% this year to 3.4% in 2027.

Overall, we expect that the labour market started to show signs of further weakening in July as rising input costs and persistent uncertainty keep hiring subdued. As a result, we expect the unemployment rate to reassert its upwards trend in H2 and only fall gradually in 2027.

We expect inflation likely jumped in August from 2.9% to 3.3% as rebounding motor fuels inflation will account for around half of this rise.

The other big driver of inflation should come from airfares which will rise from -11.6% to 3.5% as a seasonal boost lifts prices and higher jet fuel prices likely begin to be reflected in long haul fares.

For the MPC, that will leave inflation around 0.5 percentage points higher in August than the Bank expected at the time of its July meeting. However, we doubt that will be enough to convince a majority of the Committee to hike rates next week, the rise in services inflation will be almost entirely driven by airfares which are volatile, so the Bank will likely wait for more evidence of jet fuel prices feeding through to fares before taking action.

Further ahead, rebounding energy prices will keep adding to inflation in the coming months as Ofgem’s utility price cap hike rose in October and will likely jump again in January. What’s more, food and industrial goods inflation will begin to rebound at the end of the year as higher energy prices work their way through supply chains and El Niño-related weather effects damage crop yields which will further add to the former.

Ultimately, inflation will jump in August off the back of higher motor fuels inflation in August before continuing to trend up over the rest of the year peaking at 3.9% in early 2027 if energy prices hold at current levels. That will keep the MPC cautious over the rest of the year, but the weaker labour market should limit any second-round effects giving the Committee enough room to stay on hold before resuming rate cuts next year.

Our best estimate is that retail sales rose by around 0.5% in August as warm weather and rebounding consumer confidence boosted sales.

Indeed, consumer’s major purchasing intentions, the part of consumer confidence most correlated with spending, jumped from -12 to -7 in August, which was the highest since 2021 and suggests consumers were willing to keep spending in August despite rebounding fuel prices.

Admittedly, leading indicators such as the BRC retail sales data showed annual sales growth slowing. However, the official data has outperformed the steer from surveys over the last year, as our chart below shows, and retail sales undershot expectations in July, so we think some catch-up is likely.

Ultimately, retail sales should rebound in August, but we think momentum will slow over the rest of the year as higher inflation means real wage growth, at least in the private sector, will turn negative later this year dragging on consumer spending.

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