UK Interest Rates Could Surge Above 4% Amid Persistent Energy Shock, Niesr Warns
The National Institute of Economic and Social Research (Niesr) has issued a stark warning that UK interest rates could be pushed back above 4% if the ongoing conflict in the Middle East leads to a sustained spike in oil and gas prices. This economic think tank highlighted that the Bank of England will face a significant "shock" to energy costs, which could create substantial problems for Chancellor Rachel Reeves as financing costs escalate.
Energy Price Volatility and Market Disruption
Oil and gas prices have experienced sharp increases since the intensification of the US-Israel war with Iran, causing significant disruption to global commodity supplies. Iran has threatened to block the crucial shipping route, the Strait of Hormuz, in retaliation for strikes, while Qatar announced a halt in liquefied natural gas production on Monday following attacks on its facilities. The price of Brent crude oil has risen by approximately 15% since the outbreak of hostilities over the weekend, and analysts report that the European benchmark for natural gas has soared by about three-quarters.
Although price rises showed signs of steadying on Wednesday after initial spikes earlier in the week, Niesr's analysis indicates that escalating energy costs could drive up inflation in the UK. The research institute developed two scenarios to assess the potential impact: one where oil prices rise a further 30% and gas prices increase by an additional 50%.
Two Scenarios: Temporary vs. Persistent Shock
In the first scenario, if the price spike is temporary and energy prices begin to normalise after three months, the Consumer Prices Index (CPI) inflation for 2026 could rise by about 0.3 percentage points relative to previous forecasts from Niesr's February economic outlook. Under these conditions, the Bank of England and other central banks might look past the temporary energy shock, with minimal impact on interest rates, though Niesr acknowledged that policymakers could still consider it in their decisions.
The second scenario involves energy price rises persisting for a year before stabilising. This would push up CPI inflation by 0.7 percentage points in 2026 and 0.5 percentage points in 2027, while also weighing on UK gross domestic product (GDP) by 0.2 percentage points in 2026 and 0.3 percentage points in 2027. In this case, Niesr predicts that interest rates in the UK could increase by about 0.8 percentage points compared to its previous forecasts.
Implications for Monetary Policy and Fiscal Outlook
Niesr's February economic outlook had anticipated the Bank of England cutting interest rates twice this year, from the current 3.75% level to settle at about 3.25%. However, the new analysis suggests that the Bank could be forced to reverse course and push rates back up above 4%. Ed Cornforth, an economist at Niesr, emphasised that the conflict in the Middle East will have material implications for the economic outlook, stating, "The Bank of England will have to contend with a shock to global energy prices, with the question of persistence hanging over their heads. This will cause problems for Rachel Reeves as financing costs increase, putting further pressure on an already precarious fiscal outlook."
Market expectations have shifted dramatically since the weekend, with traders sharply reducing their bets on a Bank of England rate cut next week. James Smith, a developed markets economist at ING, noted, "Investors have slashed expectations for a March rate cut from the Bank of England. Markets are pricing it with just a 20% probability, down from 80% pre-conflict." Despite this, Smith maintains that UK interest rates "have further to fall," even if the next reduction is delayed, adding, "We now expect the next Bank of England cut in April though March is still a distinct possibility if Middle Eastern tensions rapidly de-escalate. With the jobs market still under pressure, further easing is still more likely than not."
