The Bank of England held interest rates at 3.75 per cent today, despite fears that the recent spike in energy prices could prompt another inflation shock.
The Monetary Policy Committee voted by a majority of 6-3 in favour of keeping interest rates at their current level for the fifth meeting in a row. Three committee members voted to increase the bank rate by 0.25 percentage points to 4 per cent.
Bank Governor Andrew Bailey said the decision was "appropriate as global conditions look to be more uncertain and inflationary." In a surprise move, rate-setter Catherine Mann changed her mind and voted for an immediate rate hike to 4 per cent alongside fellow committee members Huw Pill and Megan Greene.
Mann blamed the "collapse" of the US-Iran peace deal, the "widening of the Middle East conflict" and "associated volatility in energy prices" for her decision. The central bank now assumes inflation, which is currently at 2.6 per cent, will peak at 3 per cent later this year as household energy bills rise under the Ofgem price cap.
The Bank of England central forecast includes the recent announcement by Prime Minister Andy Burnham to cut VAT for pubs and restaurants and impose a nationwide £2 bus fare cap to ease cost-of-living pressures on households and businesses.
Under a worst-case scenario outlined by the central bank, inflation will top 4 per cent next year if oil prices go over $100 a barrel. Brent crude currently trades at around $82 a barrel.
Economic activity is expected to "weaken slightly" in the coming quarters, with "subdued" growth of just 1.1 per cent this year. Unemployment, currently at 4.8 per cent, is forecast to rise "gradually" to 5.1 per cent by the end of the year, driven mainly by "continued weak hiring" by employers rather than job losses.
Energy prices and inflation risks
The recent resumption of hostilities in the Middle East pushed oil prices to their highest level in months, with Brent crude hitting $100 a barrel last week. Although prices are now back below $90, fears persist that the prolonged closure of the Strait of Hormuz could prompt another bout of higher inflation, leading mortgage lenders to raise rates in anticipation.
Headline inflation fell by more than expected in June to 2.6 per cent, but core and services inflation stayed relatively level while private sector wage growth fell to a six-year low. Earlier this year, when oil prices hit as high as $126 a barrel, economists warned that inflation could reach 5 per cent by the summer.
The central bank said it expects the headline rate to rise later this year "as the effects of higher energy prices continue to pass through." Higher energy prices are expected to add around 0.4 percentage points to CPI in the second half of the year, while higher petrol prices will add 0.3 points.
Governor Andrew Bailey said: "Events in the Middle East mean that the short-run path of inflation is uncertain owing to volatile energy prices. The possibility of repeated resumptions of conflict, combined with lower than usual European gas stock levels and a fall in global refining output, mean that risks to energy prices lie to the upside. Set against that, the process of underlying disinflation that was intact prior to the conflict remains in train."
Food inflation is projected to rise to 3.5 per cent by the end of the year, with headline inflation expected to average 3.2 per cent in the final quarter. Central banks typically raise rates to bring down inflation and cut them once prices are back under control.
The fall in the headline inflation rate provided rate setters with enough cover to continue their "wait and see" approach. That offers better news for millions of households and businesses concerned about a sharp increase in the cost of their mortgages and other loans this summer.
Market expectations and mortgage costs
Financial markets are pricing in a single quarter-point rate rise to 4.00 per cent this year and two more to 4.50 per cent by this time next year. Fixed-rate mortgage costs, which are set by financial market expectations, have already crept higher since the Gulf conflict resumed, dampening demand in the economy.
Governor Andrew Bailey said: "Financial conditions have tightened since the onset of the conflict." He added: "Inflation has fallen faster than we'd expected. But the conflict in the Middle East continues to mean high and volatile energy prices. That will cause inflation to rise again later this year."
Lloyds Banking Group, Britain's biggest lender, expects one rate cut later next year. Lloyds Banking Group finance director William Chalmers said: "The MPC is most likely to be in wait-and-see mode for the rest of the year."
Richard Carter, head of fixed interest research at Quilter Cheviot, said the committee next meets in September and a rate rise could be possible by then. Carter added: "However, complicating matters somewhat is the expected Budget from John Healey at some point in the Autumn. With cost-of-living measures expected to be front and centre of this, as well as additional spending commitments looking likely, it may be the BoE sticks to its holding pattern before acting, offering a level of policy stability that is craved right now."
Federal Reserve interest rate stance
Yesterday, the Federal Reserve held rates at 3.5 per cent, but officials were split over how to tackle inflation, with three officials backing a rise. Federal Reserve chair Kevin Warsh, who took over in May after being appointed by President Donald Trump, said there had been "vigorous discussions."
