Preview of Bank of England Interest Rate Decision: Domestic Inflation Pressures Finally Easing, Iran Conflict Makes "No Change" the Only Consensus

According to Zhitong Finance APP, there are only three days left until the Bank of England’s interest rate decision this Thursday, and Governor Andrew Bailey has finally encountered a domestic narrative that is markedly different from previous years—the UK’s deeply entrenched domestic inflationary pressures are easing at a much faster pace than expected.

This gives the Monetary Policy Committee (MPC) valuable time to wait and see amid a new round of energy shocks triggered by the Iran-Israel war. Although the market has basically concluded that this week’s rates will remain unchanged at 3.75%, the debate over whether the next step should be a rate hike or continued rate cuts is far from settled.

Stubborn Domestic Inflation “Recedes”

For years, inflation in the UK has puzzled economists and policymakers. Even as post-pandemic global supply chain disruptions faded and neighboring countries steadily met their inflation targets, the Bank of England continued to grapple with persistent, homegrown price pressures. Now, this situation is undergoing a significant shift.

The latest data paints a picture of rapidly cooling domestic inflation. The most direct measure of domestic pressure—items in the consumer basket with the lowest import dependency, such as housing rent, haircuts, beer, etc.—now contributes the lowest share to overall inflation since the Russia-Ukraine conflict erupted in early 2022. The year-on-year increase in the overall Consumer Price Index (CPI) has slowed to 2.6%, the lowest in 15 months, with official data coming in below expectations for three consecutive months.

Another area bringing comfort to central bank officials is wage growth. Private sector regular pay growth, previously a major source of rising costs for UK firms, has now slowed to below 3% for the first time since 2020, a level considered consistent with the Bank’s 2% inflation target. Meanwhile, economic growth remains sluggish, and what was previously a very tight labor market has also loosened—job vacancies are down, unemployment is up, and workers’ bargaining power for big pay raises is fading.

Panmure Liberum’s chief economist Simon French commented, “Arguably, the current data shows that domestic input cost pressures are more moderate than at any time since the pandemic began. Therefore, the argument for the need to further tighten monetary policy is softening quite rapidly.”

Bruna Skarica, UK chief economist at Morgan Stanley, also pointed out that, although headline inflation remains above target and everyone knows the July numbers will rebound, “core services inflation has been falling for a year and nearly all pay growth indicators are moderating.”

Shockwaves from the Iran War: Oil Back Above $100

If not for a sudden geopolitical conflict, the Bank of England might have been able to lay out a rate-cutting path more comfortably. Earlier this year, markets once expected several rate cuts by 2026, but the outbreak of the Iran war completely upended those expectations. The conflict has sent international oil prices back above $100 a barrel, and rising energy costs are once again exerting an impact.

The most immediate impact is already being felt by UK households. Due to changes in the energy price cap, UK residents’ energy bills jumped 13% in July. This will almost certainly end the phase of record-low CPI readings and push inflation up again from July onwards. Although a brief ceasefire recently caused markets to reduce rate hike bets, as fighting reignited, asset prices swung sharply again.

The persisting high energy prices have also raised the Bank’s concerns over “second-round effects”—companies attempting to pass on rising costs to consumers, and workers demanding pay increases to offset higher living costs, potentially sparking a wage-price spiral. This is precisely what has been worrying the hawkish members of the MPC.

Are Hawkish Concerns Overblown?

Hawkish members, such as chief economist Huw Pill and policymaker Megan Greene, were previously wary not only of oil price shocks but also that domestic inflationary pressures had stalled even before the Iran conflict broke out. However, these concerns now seem somewhat exaggerated.

In the months since the conflict began, actual UK inflation data has been far lower than the Bank’s internal forecasts at the start of hostilities.

Paul Dales, UK chief economist at Capital Economics, said the continued downside surprises in inflation data mean that “the disinflationary momentum in the economy was stronger than we expected before the Iran war began.” The weak labor market robs workers of bargaining power, and weak consumer demand also curtails companies’ pricing power, restraining cost pass-through.

Last Friday, the Bank of England’s regional agents published their latest report, which confirmed this more moderate macro backdrop: due to weak consumer demand, supermarkets widely expect food inflation to weaken further. Year-on-year price declines in clothing & footwear, household goods, and furniture shops show retailers are having to ramp up discounts to attract cautious consumers. As a result, domestic factors have become an increasingly clear downward force.

Mild Change from New Government and Market Jitters

The new prime minister Andy Burnham and his appointed Chancellor John Healey have also brought a mild downward pull to the inflation outlook. A series of recently announced government measures, including cuts to household electricity VAT and bus fare caps on multiple routes, will, according to Capital Economics’ Dales, “have a slight downward effect on the Bank’s CPI forecasts.”

Nevertheless, as far as this Thursday’s meeting is concerned, all these developments mostly underpin the case for “holding steady” rather than pointing a new direction. Market pricing has already fully digested expectations that rates will stay at 3.75%.

Daniel Mahoney, senior UK economist at Handelsbanken, believes: “The (June) inflation data does not change any considerations for the July interest rate decision. Financial markets are pricing in two rate hikes by March next year, but the relatively weak UK labor market, coupled with major geopolitical uncertainties, means the MPC is highly likely to maintain its ‘wait and see’ approach and keep rates unchanged at this meeting.”

AJ Bell head of financial analysis Danni Hewson agrees, saying the inflation data means the Bank can wait another month to weigh its options, and the market's expectations for no change next week have been further reinforced following this data release. “But the real test comes in September. The voting split and latest forecasts at that meeting will be closely watched by investors, as they seek clues about how many more hikes may be needed to bring the economy under control.”

The Murky Second Half of the Year and the Path Ahead for 2026

Looking ahead, the outlook remains highly uncertain. The money market’s bets have swung wildly amid repeated geopolitical news, from once expecting only one rate cut this year, to recently tending to price in almost two rate hikes, only to swing sharply again as peace talks falter. It’s important to note that market pricing does not mean economists believe the Bank will necessarily follow through.

Last year, the Bank of England cut rates four times, lowering the benchmark rate to its current level. Some analysts and economists believe that the neutral rate for this cycle may be around 3%, which means there may only be three more cuts this cycle, with greater intervals as the rate approaches that level.

But even this assessment is full of uncertainties in the current environment. The next meeting on September 17, together with updated economic forecasts and the composition of the vote, will become a crucial window to reveal the policy path ahead.