The Bank of England is widely expected to keep interest rates unchanged at 3.75% on Thursday as Governor Andrew Bailey and policymakers assess whether higher energy prices caused by the Iran conflict will create sustained inflationary pressures across the UK economy.
Unlike the European Central Bank, which raised interest rates for the first time in nearly three years last week, the Bank of England believes financial conditions have already tightened significantly after abandoning earlier expectations for interest rate cuts this year.
Bailey has argued that the shift in market expectations has effectively tightened monetary policy, with higher borrowing costs already having a noticeable impact on economic activity and financial conditions across the country.
Recent economic data has reinforced concerns about slowing growth. Official figures showed the UK economy contracted by 0.1% in April after expanding by 0.3% during the first quarter, while the Confederation of British Industry has forecast unemployment could rise to 5.5%, its highest level in more than a decade.
Against this backdrop, the Bank of England believes inflation could rise above 3.5% later this year. While higher prices may increase pressure on household finances and raise inflation expectations, policymakers currently see a lower risk of a prolonged wage-price spiral due to weakening economic conditions.
Economists say softer labour market conditions could limit workers’ ability to secure stronger pay rises, reducing the likelihood that higher inflation expectations become embedded in wage growth and consumer spending behaviour.
Financial markets have also scaled back expectations for further monetary tightening. Following signs of potential progress towards a ceasefire in the Iran conflict, investors no longer expect an immediate rate increase and are not fully pricing in a Bank of England hike until November.
Earlier in the conflict, markets had anticipated as many as four interest rate increases this year, highlighting how expectations have shifted as economic growth slows and inflation risks become more balanced.