With just three days remaining until the Bank of England's interest rate decision this Thursday, Governor Andrew Bailey has finally encountered a domestic narrative starkly different from the past several years. The UK's deeply entrenched domestic inflationary pressures are receding at a faster-than-expected pace. This grants the Monetary Policy Committee (MPC) valuable time to adopt a wait-and-see approach amid the new energy shock triggered by the US-Iran conflict.
While the market has largely priced in a decision to hold rates at 3.75% this week, the debate over whether the next move will be a hike or a continuation of cuts is far from settled.
Stubborn Domestic Pressures Recede
For years, the UK's inflation conundrum has puzzled economists and policymakers. Even as post-pandemic global supply chain shocks faded and neighbouring countries successively stabilized their inflation targets, the Bank of England continued grappling with unique, stubborn domestic price pressures. Now, this dynamic is changing significantly.
Latest data paints a picture of rapidly cooling domestic inflation. The contribution of items with the lowest import dependency within the consumer basket—such as housing rents, haircuts, and beer—to headline inflation has fallen to its lowest level since the outbreak of the Russia-Ukraine conflict in early 2022. The annual headline Consumer Price Index (CPI) has slowed to 2.6%, a 15-month low, with official data undershooting expectations for three consecutive months.
Providing further relief to central bank officials are developments in the wage sector. A key source of rising business costs, private sector regular pay growth has slowed to below 3% for the first time since 2020, a level considered consistent with the central bank's 2% inflation target. Concurrently, economic growth is sluggish, and the once extremely tight labour market has loosened significantly, with fewer job vacancies and rising unemployment, diminishing workers' leverage for substantial pay rises.
Simon French, Chief Economist at Panmure Liberum, commented, "The evidence suggests that domestic input cost pressures are now as benign as at any time since the pandemic began. Consequently, the argument for continued monetary tightening is softening quite rapidly." Bruna Skarica, UK Chief Economist at Morgan Stanley, also noted that while headline inflation remains above target and everyone is aware of a July rebound, "core services inflation has been trending down for a year, and almost all measures of pay growth are also declining."
Iran Conflict Shockwave: Oil Back Above $100
Had it not been for a sudden geopolitical conflict, the Bank of England might have been able to plan its easing path more comfortably. Earlier this year, markets anticipated multiple rate cuts in 2026, but the outbreak of the Iran conflict has completely upended this outlook. The war has pushed international oil prices back above $100 per barrel recently, with the transmission effects of surging energy costs becoming apparent once again.
The most direct impact has already fallen on UK households. Due to an update in the energy price cap, household energy bills surged by 13% in July. This almost certainly spells the end of the CPI's recent phase of low points, pushing inflation higher again from July data. While a brief ceasefire recently led to a reduction in rate hike bets, the resumption of hostilities has pushed asset prices back into sharp volatility.
Sustained high energy prices also raise concerns within the central bank about "second-round effects"—businesses attempting to pass on higher costs to consumers and workers demanding pay rises to compensate for the cost-of-living squeeze, potentially triggering a wage-price spiral. This is a primary source of anxiety for the hawkish members within the MPC.
Are Hawkish Concerns Exaggerated?
Hawkish committee members, represented by Chief Economist Huw Pill and rate-setter Megan Greene, were not only wary of the oil price shock but also feared that the momentum of easing domestic inflation pressures had stalled even before the Iran conflict erupted. However, these concerns now appear to be overstated.
In the months since the conflict began, actual UK inflation data has consistently fallen short of the central bank's initial internal forecasts made at the conflict's onset. Paul Dales, Chief UK Economist at Capital Economics, stated that the ongoing downside surprises in inflation data indicate "the disinflationary momentum within the economy was stronger than we anticipated before the Iran war began."
A weak labour market leaves workers with little bargaining power, and sluggish consumer demand similarly strips businesses of pricing power, curbing cost pass-through. A report released last Friday by the Bank of England's regional agents confirmed this more benign macro backdrop: due to weak consumer demand, supermarkets generally expect further food price weakness. Year-on-year price declines in clothing, footwear, household goods, and furniture stores suggest retailers are being forced to increase discounts to attract cautious consumers. This makes domestic factors an increasingly clear downward force on the scale.
The New Government's Ripples and Market Jitters
Newly appointed Prime Minister Andy Burnham and his chosen Chancellor of the Exchequer, John Healey, are also providing a modest downward pull on the inflation outlook. The government's recent announcements of measures, including cutting VAT on household electricity and capping fares on several bus routes, which Capital Economics' Dales believes "will exert a slight downward pressure on the Bank's CPI forecasts."
However, for this Thursday's meeting, all these changes serve more to consolidate the rationale for "holding steady" than to point in a new direction. Market pricing has fully absorbed the expectation of rates remaining at 3.75%. Daniel Mahoney, Senior UK Economist at Svenska Handelsbanken, argues, "The (June) inflation data has changed nothing regarding the considerations for the July rate decision. Financial markets are pricing in two rate hikes by March next year, but the relatively weak UK labour market, coupled with massive geopolitical uncertainty, means the MPC is highly likely to maintain its 'wait-and-see' stance and keep rates unchanged at this meeting."
Danny Hewson, Head of Financial Analysis at AJ Bell, concurred, stating that the inflation data allows the Bank to wait another month to weigh its options, with the market expectation of a hold next week actually consolidated further after the data release. "But the real test comes in September. The voting split and updated forecasts at that meeting will be closely watched by investors seeking clues on how many rate hikes are ultimately needed to bring the economy under control."
A Foggy Outlook for the Second Half and 2026
Looking ahead, the outlook remains exceptionally unclear. Money market bets have swung wildly amid repeated geopolitical news, oscillating from pricing only one rate cut for the year to recently favouring close to two hikes, before swinging sharply again due to the volatility in peace talks. It is worth noting that market pricing does not necessarily mean economists believe the central bank will follow through.
The Bank of England cut rates four times last year, bringing the benchmark rate to its current level. Some analysts and economists believe the neutral rate for this cycle could be around 3%, implying potentially only three more rate cuts in total over the cycle, and with the gap between cuts likely widening as rates approach that level. However, in the current environment, even this assessment is fraught with uncertainty. The next meeting on September 17, accompanied by the committee's updated economic forecasts and voting composition, will serve as a critical window to reveal the policy path ahead.
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