Bank of England holds at 3.75% as Iran war lifts inflation forecast to 4%

Bank to sell £146bn of gilts to Treasury at £20bn a year through 2034

The Bank of England held its benchmark interest rate at 3.75% on Thursday but warned that a prolonged war in the Middle East could force future borrowing-cost increases as energy prices push inflation higher. The Monetary Policy Committee voted 6-3 to keep the rate unchanged, with three members backing an immediate quarter-point increase.

The decision comes as the global energy shock tied to the Iran war lifted UK inflation to 3.1% in August from 2.9% in July, and followed rate increases last week by the European Central Bank and on Wednesday by the U.S. Federal Reserve.

Governor Andrew Bailey framed the hold as conditional on how long the energy shock persists. “So far higher global energy costs have had a limited effect on price and wage setting in the UK,” Bailey said. “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 [the] Bank rate to ensure that inflation falls back to our 2% target.”

Highlighting the risk to the economy as the Iran war intensifies, the Bank said inflation was on track to reach 4% by early next year, as the surge in energy prices hits households with a fresh cost of living crisis. Three members of the MPC were outvoted with a call for an immediate quarter-point increase in the base rate.

The MPC said there was not yet a need to act because there had been “little evidence so far of material second-round effects” — when inflationary pressures push businesses and workers to demand higher prices and pay settlements. There were also signs of weaker food price inflation despite the surge in energy prices triggered by the Iran war, the Bank added.

Against a volatile backdrop in global financial markets, Threadneedle Street also announced updated proposals for winding down its financial crisis-era quantitative easing programme, which at its peak involved the Bank buying £895 billion of UK government bonds. In an unexpected move, the Bank said it planned to sell £146 billion of bonds back to the Treasury at a pace of about £20 billion a year until 2034, a plan that would require agreement from the chancellor.

The process is intended to complete the Bank’s “quantitative tightening” programme, which has involved gilt sales since 2022 and reduced the Bank’s holdings to about £488 billion. The Bank said it would retain about £120 billion of bonds on its balance sheet to back the issuance of notes and coins circulating in the economy. However, it would pause active gilt sales until a deal with the government is reached on what to do with the remaining assets.

About £222 billion of bonds would be disposed of through a mixture of allowing the debts to mature and through active sales. If a deal to sell them back to the Treasury is not agreed, the Bank would resume selling the bonds to institutional investors.

Financial markets had expected the Bank would keep borrowing costs unchanged as policymakers grapple with the worsening global energy shock at a time when the domestic jobs market is coming under strain. The Treasury decision could have significant consequences for the public finances before next month’s budget.

It came after Andy Burnham said he was prepared to take “difficult decisions” to tackle high inflation and keep the economy on track and would take action at next month’s budget on the cost of living.

Official figures on Wednesday showed UK inflation rose to 3.1% in August from 2.9% in July as the escalating Middle East hostilities drove up the average price of petrol and diesel by almost a quarter, hitting households already squeezed by years of fast-rising prices for everyday essentials. The Bank’s inflation target is 2%.

The sharp rise in global energy prices prompted the U.S. Federal Reserve to raise interest rates on Wednesday for the first time since 2023, after a decision last week by the European Central Bank to raise eurozone borrowing costs.

With the Bank under pressure to guard against high inflation becoming entrenched in the UK economy, City traders are pricing a quarter-point rise in borrowing costs as early as November and three more increases next year that would take the base rate to 4.75%.