By The Bank of England kept interest rates unchanged on Thursday but warned that a prolonged conflict in the Middle East could push inflation higher and force it to raise borrowing costs again.
The Monetary Policy Committee voted 6-3 to leave the Bank Rate at 3.75%, even as surging energy prices and rising UK inflation increase pressure on policymakers.
The decision came against a backdrop of divergent global monetary policy.
The Federal Reserve and European Central Bank have raised rates, while the Bank of Japan is widely expected to increase its key rate after concluding a two-day meeting on Friday.
Alongside its rate decision, the Bank announced an unexpected plan to sell £146 billion of UK government bonds directly to the Treasury.
The proposal is intended to help complete its quantitative tightening programme and could ease some pressure on the gilt market, although it requires approval from the chancellor.
Bailey warns energy shock could revive inflation
The Bank highlighted the risk that continued fighting in the Middle East could transmit higher energy prices into household costs, wages and broader inflation.
Andrew Bailey, the Bank’s governor, said: “So far higher global energy costs have had a limited effect on price and wage setting in the UK.
“But the longer this volatility persists, the bigger the impact it will have on inflation, and the more likely it is we will need to raise Bank rate to ensure that inflation falls back to our 2% target.”
The Bank warned that inflation could reach 4% by early next year as higher energy costs feed through to households, potentially creating another cost-of-living squeeze.
Three members of the MPC — Megan Greene, Catherine L Mann and Huw Pill — voted for an immediate 25-basis-point increase.
According to the meeting minutes, the three members pointed to the escalation and duration of the Middle East conflict as factors that could keep energy and food prices elevated.
They also cited global factors including AI-related supply constraints and El Niño as potential sources of additional inflationary pressure.
They expected inflation to peak in early 2027, around the time when wage settlements are agreed.
UK inflation climbs above 3%
The Bank’s cautious stance comes after official data showed UK inflation accelerated in August.
The inflation rate rose to 3.1%, marking its first move above 3% since March, according to data released by the Office for National Statistics on Wednesday.
The increase was driven largely by higher motor fuel costs, which rose 23% year-on-year.
The UK’s position as a net energy importer leaves the economy particularly exposed to sharp movements in global energy prices.
Households are also still dealing with the effects of the post-Covid inflation surge and the energy shock associated with Russia’s invasion of Ukraine.
The latest increase in inflation complicates the Bank’s efforts to balance price stability against economic growth.
While the MPC opted against another rate increase, the prospect of renewed tightening remains firmly on the table if energy-driven inflation becomes embedded in wages and prices.
Gilt yields retreat after volatile week
British government bond yields eased on Thursday, providing some relief following a sharp sell-off earlier in the week.
The 10-year gilt yield fell six basis points to 5.23%, moving further away from the 19-year highs reached earlier in the week.
The 30-year gilt yield declined seven basis points to 5.79%. It had climbed to its highest level since 1997 just days earlier.
UK government bonds have faced sustained pressure this year amid concerns over global inflation, political uncertainty and the country’s fiscal position.
Britain currently has the highest borrowing costs among G7 economies, with yields on long-dated 20- and 30-year gilts approaching 6%.
The prospect of higher energy prices has added another challenge for investors already demanding greater compensation for holding longer-dated government debt.
Bank plans £146bn bond transfer to Treasury
The Bank also unveiled updated plans for winding down its financial-crisis-era quantitative easing programme.
The central bank accumulated £895 billion of UK government bonds at the peak of its asset-purchase programme.
Since 2022, it has been reducing those holdings through quantitative tightening, bringing its stock of gilts down to about £488 billion.
Under the new proposal, the Bank would sell £146 billion of bonds directly to the Treasury at a pace of roughly £20 billion a year until 2034.
The plan requires the chancellor’s approval.
Selling the bonds directly to the government, rather than placing them back into an already volatile market, could reduce some pressure on gilt yields.
It could also lower losses associated with the Bank’s quantitative easing programme and its eventual impact on public finances.
For investors, the move introduces another important factor into the outlook for UK government debt.
The immediate relief in gilt yields following Thursday’s decision contrasts with the longer-term challenge posed by inflation, fiscal concerns and the possibility of renewed monetary tightening.
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