Inflation forecast could peak above 4%, suggesting an early-year rate increase

Economists expect the Bank of England to raise its key interest rate to 4% from 3.75% on Thursday to help contain a pickup in inflation as the war between the U.S. and Iran has lifted energy prices. The expected increase would place the Bank of England alongside the Federal Reserve, the European Central Bank and the Bank of Japan, each of which has raised its key interest rate at least once since the war began.

Why the Bank of England held back

The Bank of England had remained on the sidelines. A majority of officials pointed to its key rate being higher than those of its European counterparts when the war started, while a rise in bond yields helped cool inflation at a time of weak demand and a softening jobs market.

The Bank of England is expected to join its peers in raising borrowing costs Thursday as it attempts to contain a pickup in inflation ahead of an intense period of wage negotiations, but it may signal that it does not intend to move as aggressively as some investors anticipate.

The longer the war lasts, the more likely higher energy costs will lead to increases in the prices of other goods and services. In recent weeks, Bank of England officials have indicated that an increase to 4% from 3.75% is likely. “We expect the Bank of England’s patience to have run out with the unfolding energy shock,” economists at Deutsche Bank wrote in a note to clients.

Forecast, rate expectations and official signaling

Bank of England officials are also expected to raise their inflation forecast from 3.5% in September to a peak that could exceed 4% in the early months of next year. The revision anticipates a large rise in home-energy prices taking effect in January. That higher forecast suggests the Bank of England may lift its key rate again early in the new year. Economists expect officials not to endorse market expectations that see the key rate peaking at 5%.

Bank of England Chief Economist Huw Pill last month said he was “skeptical” of those expectations. His remarks were seen as significant for the Monetary Policy Committee as a whole because Pill has been its most persistent advocate for higher interest rates, and his less-hawkish colleagues are therefore likely to be even less persuaded that a move of that size is needed. It is also likely that some committee members will vote Thursday to leave the rate unchanged at 3.75%.

Economists at Oxford Economics wrote, “It’s possible that the meeting minutes or Governor Andrew Bailey in the post-meeting press conference could signal that Bank Rate is unlikely to reach the level that is priced in by financial markets.” The economists identified the minutes and Bailey’s post-meeting press conference as possible channels for that message.

Pay talks and business surveys

The round of pay negotiations due to start in early 2027 is likely to be key to the ultimate peak for the key rate. Since the war started, the Monetary Policy Committee has said its main goal is to prevent second-round effects, which can take the form of an acceleration in wages that leads businesses to raise prices as they defend profit margins. So far, officials have seen few signs of that dynamic.

A Bank of England survey published Friday found businesses expect wages to increase at a slower pace over the coming 12 months than during the previous year. The survey provided the latest indication of the wage dynamic that officials have said they are watching as energy costs rise.

As colder weather leads Britons to heat their homes, rising energy prices will bite over the coming months. Higher bills may yet persuade workers to ask for big pay increases, although it is unclear whether businesses would be willing to grant them or, if they did, could pass the higher costs on to customers. Because the early-2027 negotiations are likely to be key to the ultimate rate peak, any effect of higher bills on wage demands could affect that path.

The same Bank of England survey found 71% of businesses expect the war to lead to narrower profit margins, an indication that they do not expect to recover higher costs through higher prices.