Inflation held steady at 3% in February. However, surging energy costs mean the UK outlook for inflation has radically shifted since last month. Revised forecasts based on current energy prices show inflation is likely to peak at between 3.5% and 4% in the second half of this year.

As a result, financial markets have gone from pricing in two interest rate cuts this year to two rate hikes instead. However, given the weakness of the UK economy, especially the labour market, a prolonged hold or a short tightening cycle looks more likely than a series of rapid rate rises.

UK inflation steady in February

Inflation was stable and above the 2% target in February. A big jump in clothing and footwear added 5bps and household goods added a similar amount as retailers’ January sales ended.

Offsetting this was motor fuels inflation, which dropped to -4.6% from -2.2%. However, the Middle East crisis means that this will reverse − and then some − in March and April as higher oil prices make their way through to petrol forecourts.

This all makes February’s inflation report feel somewhat irrelevant to firms, households and the Monetary Policy Committee (MPC), which is now far more worried about rising energy prices.

In the near-term, we expect inflation to rebound to 3.2% in March as oil prices begin to show up in higher pump prices. There’s also an upside risk from heating oils, where prices have risen far more than crude oil since the outbreak of the conflict.

Iran conflict now means rising UK inflation

Further ahead, inflation will still slow a little further in April, but the big rise in fuel prices means it will probably drop to only about 2.8% rather than close to the 2% we were previously expecting. That’s even as last year’s swathe of regulated price hikes drops out of the annual comparison and the Chancellor’s decision to move some policy costs to general taxation, which will see the energy price cap drop by 6.7%, is accounted for.

More importantly, we think inflation is likely to rise to around 3.5% in July if the energy price cap rises by 15−20%, which it would do based on current energy prices. Indirect effects, such as higher airfares, will add to services inflation, while increased transportation costs will show up in goods inflation. These will compound the hit to the headline rate later in the year and could push it towards 4% by the end of 2026. For food specifically, the Middle East is an important producer of fertilisers. So, any prolonged disruption in the Strait of Hormuz is likely to boost food inflation even further.

However, we think second-round effects from wage bargaining are less likely now than in 2022. The labour market is much weaker than it was a few years ago, which means workers will find it harder to bid up their nominal wages. Meanwhile, the weaker demand backdrop will make it harder for firms to aggressively pass on price increases.

MPC on hold in 2026, but hikes on the table

As a result, our base case is for the MPC to remain on hold this year, instead of hiking rates twice as financial markets currently expect. The MPC will want to avoid weighing on a weak economy and labour market, especially if second-round effects seem less likely.

Admittedly, the MPC minutes last week were slightly more hawkish than we had expected, suggesting a lower bar to rate hikes. Simultaneously, the latest Citi/YouGov data shows that household inflation expectations jumped sharply in March to levels last seen in 2023 when inflation was over 10%. That will make the MPC nervous and could tempt the more hawkish members of the Committee to argue for a tougher approach to rising energy prices to ensure second-round effects don’t materialise.

That said, if there is a tightening cycle, then it’s likely to be short and shallow as the MPC quickly shifts its attention back to the hit to demand and employment. Indeed, inflation would fall back sharply to target in 2027 as base effects from recent rises in energy prices and a larger output gap from a weaker economy weigh on inflation.

Ultimately, February’s CPI report will have little bearing on the MPC’s considerations as its focus has firmly shifted to the recent rise in energy prices, which will only start to appear in the data from March. We think the MPC will balance the downside risks to demand with accelerating inflation by remaining on hold this year, while signalling that it stands ready to hike rates if necessary.

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