Interest rates ‘could surpass 4pc’ amid ongoing conflict in Iran

Interest Rates May Climb Above 4% Amid Rising Energy Costs

Economists are cautioning that interest rates could surpass 4% if oil and gas prices continue to escalate. The National Institute of Economic and Social Research (NIESR) has highlighted that borrowing expenses may increase as surging energy costs threaten to drive inflation higher.

Ben Zaranko from the Institute for Fiscal Studies has also indicated that higher rates might be required to keep inflation under control. He referenced projections from the Office for Budget Responsibility (OBR), which suggest the Bank of England may need to raise borrowing costs to combat rising prices.

An OBR official noted that if the recent spike in oil prices persists, inflation in 2027 could be 1% higher than previously anticipated. David Miles, a member of the OBR’s budget responsibility committee, explained at a Resolution Foundation event that this estimate was based on preliminary calculations reflecting recent market movements.

This scenario poses challenges for Chancellor Rachel Reeves, who is relying on lower borrowing costs to balance the budget and boost public spending. Analysts further warn that living standards across the UK are likely to deteriorate before the next general election, casting doubt on claims that households will be £1,000 better off.

The Resolution Foundation, a think tank, predicts that a temporary improvement in living standards this year will be followed by a downturn, as workers contend with slower wage growth and increased taxes.

Most Gains in Disposable Income Already Realized

On Tuesday, the Chancellor stated that the average household would be £1,000 better off by 2029 due to rising real household disposable income. However, OBR data reveals that much of this improvement occurred over the past two years.

Ruth Curtice, director at the Resolution Foundation, emphasized that approximately two-thirds of the increase has already taken place, remarking, “So people have already had that. The party happened and you missed it.”

Last month, the Bank of England kept rates steady at 3.75% after a close 5-4 vote. However, the ongoing conflict in Iran has cast uncertainty over the possibility of further rate reductions.

Market expectations for a rate cut later this month have dropped sharply—from an 86% probability on Friday to just 27%—following the Middle East crisis, which has caused the most significant oil and gas price shock since Russia’s invasion of Ukraine in 2022.

Geopolitical Tensions Impact Economic Outlook

Iran recently claimed to have full control over the Strait of Hormuz, a crucial passage for a quarter of the world’s oil and a fifth of its natural gas exports. Meanwhile, gas facilities across the Middle East have suffered drone attacks, forcing energy producers to scale back output.

Money markets now anticipate only one additional rate cut this year, from 3.75% to 3.50%, down from two cuts expected last week. NIESR has warned that rates could rise by up to 0.8 percentage points this year if oil prices reach $100 per barrel and remain elevated.

Ed Cornforth, an economist at NIESR, stated, “The conflict in the Middle East will have significant consequences for the economic outlook. The Bank of England will need to address a shock to global energy prices, with uncertainty about how long these effects will last.”

Ben Zaranko did not dismiss the possibility of rates rising to 4% as the Bank of England’s next move. He suggested that, in the near term, instead of rates increasing, it may simply mean that anticipated rate cuts do not materialize. He also noted that it is too early to predict the future path of borrowing costs, but pointed out that households have experienced a series of one-off shocks, making expectations of higher prices more persistent.

Living Standards Face Further Pressure

The anticipated drop in household disposable income before the next election comes as the OBR expects wage growth to slow in the coming years. James Smith of the Resolution Foundation described the outlook for living standards towards the end of the decade as “definitely bleaker.”

He added that living standards are being squeezed by sluggish economic growth, higher taxes, and elevated living costs. The Joseph Rowntree Foundation has also warned that lower-income families will see only a modest £40 annual improvement in their finances after accounting for housing costs.

Chris Belfield, chief economist at the Joseph Rowntree Foundation, remarked that the slow growth in disposable incomes is insufficient in an increasingly unpredictable environment.