The continuing rise of oil and gas prices is threatening another inflation shock for UK households amid fears of multiple interest rate hikes this year.
With the US and Iran locked in a war which has seen the Strait of Hormuz closed off, the rest of the world is set to pay the price, with higher energy costs driving up prices in transport, fuel and production.
Rising costs mean inflation figures will be pushing higher once more. It comes just as data was showing inflation returning towards the chancellor Rachel Reeves’s 2 per cent target after three years.
One of the major methods to combat inflation is for central banks to raise interest rates, so money market traders are betting on up to four rate hikes throughout 2026, compared to a prediction of two cuts for the year as recently as four weeks ago.
“The latest bout of volatility reflects markets beginning to price in meaningful medium‑term damage to Western economies,” Jonathan Raymond, investment manager at wealth management experts Quilter Cheviot, said.
“The UK and Europe look more exposed than the US because of their reliance on imported energy, and that is now feeding into expectations of weaker consumer spending, softer growth and pressure on corporate earnings.”
It is important to note the fact that traders are making bets on the markets does not always mean the central bank, in this case the Bank of England, will also react.
Bets made on the market by selling off bonds (or gilts) send the yield higher. Buying them has the opposite effect. The two-year UK gilts yield at 11am GMT stood at 4.7 per cent, just shy of a full 1 per cent higher than the actual BoE base rate, which stands at 3.75 per cent after last week’s 9-0 vote to hold. In very simple terms, that suggests the markets are pricing in for the interest rate to go higher, up to that 4.7 per cent point, which when translated to MPC voting terms means they’d have to opt to raise (almost) four times to reach it.
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However, markets can shift very quickly in both directions when external events – such as political leaders making statements – dictate a potential change of course.
As an example, Donald Trump’s comments about having had “productive conversations” with Iran immediately saw the same market drop to 4.55 per cent; in MPC terms, therefore, back to only three interest rate hikes.
Bets in the market are not the same as actual predictions of what happens six months down the line; they are, in part, traders taking short-term positions which they may quickly sell again within short timeframes.
Matthew Amis, investment director at wealth manager Aberdeen, is one of those who believes traders in the market have overdone it for the current circumstances and does not believe such sharp rises in the interest rate are imminent.
“We don’t think Bank of England communication was as hawkish as the market move suggests,” he said. “Governor Andrew Bailey did not sound like a man who was going to raise rates three times by September. With regards the fiscal package offered by the Labour administration, only time will tell, but note the April price cap already protects consumers somewhat until the July price cap is announced in May.
“All the gilt market needs is people to starting buying. However, to do that we need some confidence and to get that we need de-escalation in the Middle East.”
In terms of the BoE raising interest rates, the difficulty comes with a poorly performing economy, rising unemployment and other domestic economic factors, most of which at present point to needing rate cuts. This is why, before the missiles started to fall, the expectation was on a cut to 3.5 per cent in March or April.
“Central banks are in a tough spot. They cannot afford to let inflation expectations drift higher, yet labour markets are already weakening and any further tightening risks amplifying that slowdown. The result is a policy backdrop that feels tougher than the data would normally warrant, which is amplifying the swings we are seeing across equity markets,” said Mr Raymond.
Analysts at Barclays, in fact, think the BoE will refrain from making any changes whatsoever.
“We expect Bank Rate to stay at 3.75 per cent for the rest of this year. We assess that keeping policy this restrictive for an extended period is sufficient to bring headline CPI inflation back to 2 per cent in two years time, consistent with the BoE’s mandated target,” a research note from Jack Meaning on Friday read.
KPMG, meanwhile, is in fact sticking to a potential cut still coming later in 2026. “The Bank of England is expected to take a cautious approach to monetary policy. KPMG UK forecasts that interest rates will be cut only once this year, as policymakers remain concerned about persistent inflationary pressures,” said chief economist Yael Selfin on Sunday.
“Further rate cuts are now likely to be delayed until 2027, as the Bank balances the risks of rising prices against a weakening labour market and sluggish economic growth.”
The BoE will also need to weigh what has already happened in Iran against what they are guessing happens next.
“Inflation is expected to rise in March as the initial impact of higher fuel prices begins to show up in the official data,” explained Thomas Pugh, chief economist at audit and tax firm RSM UK.
“As pump prices rise to around £1.60 per litre by April, we expect inflation to fall only a little, compared to slowing to 2 per cent as previously forecast. Further ahead, the rise in natural gas prices will see Ofgem increase the energy price cap in July, exerting further upwards pressure on inflation and taking it back over 3 per cent.”
Oxford Economics has an even higher expectation of inflation hitting 4 per cent in the latter half of 2026, before falling back.