Following the US Federal Reserve's decision to hold interest rates steady, the Bank of England also opted to keep its benchmark rate unchanged at 3.75%. Policymakers are attempting to balance renewed threats from escalating US-Iran tensions against signs that domestic price pressures are easing faster than anticipated. Minutes from Thursday's meeting revealed that the Monetary Policy Committee (MPC) voted 6-3 to maintain the rate, with Chief Economist Huw Pill and external members Megan Greene and Catherine Mann advocating for a 25-basis-point hike. In June, only Pill and Greene had supported immediate action.
The British pound rose and UK government bonds gained following the announcement of the decision and the vote split. Traders now anticipate a total of 35 basis points in rate hikes by December. The pound climbed to a one-week high against the US dollar. The two-year gilt yield, which is most sensitive to monetary policy changes, fell 8 basis points to 4.37%, while the benchmark 10-year yield declined 3 basis points to 5.01%.
The simultaneous appearance of three dissenting votes for a rate hike at both the Bank of England and the Federal Reserve does not necessarily signal an inevitable rate hike at the next meeting. Instead, it indicates a shift in the policy reaction function from "waiting for inflation to fall" to "preventing an energy shock from becoming entrenched." The Federal Reserve voted 9-3 to hold the federal funds rate at 3.50%-3.75%, while the Bank of England voted 6-3 to hold its bank rate at 3.75%. All dissenters in both camps called for an immediate 25-basis-point increase. The hawkish faction at the Bank of England also expanded from two members in June to three.
While wage and labor market pressures in the UK are easing, the risk to energy prices is clearly tilted to the upside due to recurring US-Iran conflicts, reduced refining capacity, and low European natural gas storage levels. The Bank of England's baseline scenario forecasts inflation rising to 3.2% by the end of the year, while an adverse scenario could see it climb above 4% by 2027. Consequently, both central banks are currently in a state of "hawkish pause": rates are temporarily unchanged, but the next move is more likely a hike than a cut.
The Bank of England's policymakers have retained policy optionality, maintaining guidance that the committee is "ready to act" to prevent high inflation from persisting, while grappling with recent sharp volatility in energy prices. The highly unpredictable environment means that oil and gas prices in the days leading up to the decision were significantly higher than the average levels the Bank of England had assumed in its baseline forecast just ten days earlier. However, the MPC noted that signs of easing domestic inflationary pressures are "clear" and there is "little evidence" so far that the energy shock has pushed up wage demands or prices in other sectors.
Most policymakers who voted to hold rates also indicated that their stance could change if the conflict were to end quickly. This group, which includes Deputy Governor Dave Ramsden, suggested they would consider cutting rates under such circumstances. Bank of England Governor Andrew Bailey stated, "There is currently little evidence of second-round effects, but it is too early to feel relieved about that. Given that the global macroeconomic environment appears more uncertain with stronger inflationary pressures, while the domestic environment is generally more benign for the inflation outlook, keeping the bank rate unchanged is appropriate."
The geopolitical conflict in the Middle East has entered its sixth month, with intermittent negotiations showing little sign of leading to lasting peace. Although current inflation is broadly in line with the Bank of England's spring projections, price growth is expected to accelerate in the coming months, driven by a rise in household energy bills in July and another increase in motor fuel costs. The Bank of England has reinstated its central inflation forecast, which was abandoned in April, and has also published "benign" and "adverse" scenarios to illustrate potential paths for oil and gas costs.
The central bank's macroeconomic projections, based on a 15-day snapshot of energy prices up to July 20, show UK inflation peaking at 3.2% by the end of the year, up from its current level of 2.6%. It would then fall back towards the Bank of England's 2% target next year. In a more pessimistic scenario, where oil prices rise above $100 per barrel and stay high, and natural gas prices increase by 60%, the Bank of England expects inflation could peak at 4.5% in the second quarter of 2027. In a more optimistic scenario, where the Middle East conflict is resolved more quickly, price growth would peak at 3% with fewer second-round effects. Across all three scenarios, UK GDP growth hovers around 1% in 2026 and 2027 before recovering in 2028.
Weak economic growth, easing domestic price pressures, and tighter financial conditions have given the Bank of England's MPC some time to assess the impact of the conflict on the UK economy. Vacancies and private-sector wage growth are at their lowest levels since the start of the Covid-19 pandemic. This labor market condition may help dampen the possibility of the energy shock triggering second-round effects and exacerbating inflation. Despite the Bank of England's inaction so far, traders in the interest rate futures market, just before Thursday's decision, saw a slightly greater than 50% probability of a 25-basis-point hike at the September meeting. The market was pricing in just under 40 basis points of cumulative tightening by the end of the year.
Oil and gas prices, which are crucial to the UK's inflation outlook, have experienced a tumultuous month, casting a shadow over the Bank of England's prospects. Brent crude oil rose from a low of just over $70 per barrel in early July to above $100 per barrel last week, before retreating to around $90 per barrel on Wednesday. The US Federal Reserve also decided on Wednesday to hold its interest rate steady at 3.5% to 3.75%, though three policymakers voted for a hike. Fed Chair Kevin Warsh insisted the central bank would act if there were signs that inflation would remain high for longer. Despite this, long-term US Treasuries fell sharply due to market concerns that the Fed is too slow in curbing inflation, which has been above its target for five consecutive years.
The Bank of England also provided its first hints about the future path of quantitative tightening, stating that a decision on next year's plan will be made in September. The Bank noted that the impact of balance sheet reduction has been relatively mild, although its estimate of the boost to 10-year gilt yields was raised to 20-30 basis points, 5 basis points higher than last year's estimate.
The coordinated appearance of three dissenting votes at both the Bank of England and the Federal Reserve signals that their decision to hold rates is not a dovish move. Instead, global interest rates are entering a phase of war-driven inflationary stress testing. The Federal Reserve voted 9-3 to hold the federal funds rate at 3.50%-3.75%, and the Bank of England voted 6-3 to hold its bank rate at 3.75%. All dissenters demanded an immediate 25-basis-point hike, highlighting that the global central bank policy reaction function has shifted from "waiting for inflation to fall" to "preventing an energy shock from becoming entrenched."
In comparison, the Bank of England's stance is closer to a two-way conditional option. Policy will be tightened if the energy shock persists and triggers second-round effects on wages, inflation expectations, and corporate pricing. Conversely, if the conflict ends quickly, energy prices fall, and the domestic disinflation process continues, some members have clearly stated they could resume cutting rates. The Federal Reserve faces a constraint more related to credibility risk. Chair Warsh emphasized an "unwavering" commitment to fighting inflation and a willingness to act without hesitation, but he refused to provide a clear rate path and noted that rising bond yields have already tightened financial conditions on behalf of the central bank.
The market has not interpreted the pause as safe patience but rather as a fear that the Fed is acting too slowly and will eventually need to hike more aggressively. After the meeting, the probability of a September rate hike was around 57%, and the cumulative expected tightening by year-end was about 35 basis points. The 30-year Treasury yield broke above 5.20%, reaching its highest level since 2007, creating a classic bear steepening of the Treasury curve, with short-end yields continuing to fall while long-end yields rise.
In terms of financial market investment strategy, the latest policy moves from the Bank of England and the Federal Reserve mean the traditional logic that "a central bank rate pause benefits all duration assets" is temporarily invalid. As long as oil prices remain elevated in a volatile range and the risk of second-round inflation has not disappeared, long-duration nominal government bonds, high-valuation growth stocks, and highly leveraged companies will continue to face dual pressure from higher real discount rates and rising term premiums. In contrast, short-duration government bonds, cash-like assets, value stocks with pricing power and stable cash flows, and inflation-hedging assets like energy and Treasury Inflation-Protected Securities offer a comparative advantage.
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