The UK may soon face a rise in interest rates above 4% due to surging energy prices linked to the escalating conflict in the Middle East, warns the National Institute of Economic and Social Research (Niesr). As oil and gas prices soar, the Bank of England must navigate the potential economic fallout, which could complicate fiscal policies and inflate living costs for consumers.
The Energy Shock Explained
The recent intensification of hostilities between the US and Israel against Iran has created significant disruptions in global energy supplies. Niesr highlights that this “shock” could have lasting implications for the UK’s economic landscape, particularly as Iran has threatened to disrupt key shipping routes in the Strait of Hormuz. Concurrently, Qatar announced a halt in liquefied natural gas production following attacks on its facilities.
Since the conflict escalated, the price of Brent crude oil has surged approximately 15%, while the European benchmark for natural gas has skyrocketed by nearly 75%. Although there was a slight cooling of prices mid-week, the overarching trend indicates that energy costs remain elevated.
Forecasting Inflation and Interest Rates
Niesr’s analysis presents two potential scenarios for energy prices. In the first, if prices stabilise within three months, Consumer Prices Index (CPI) inflation for 2026 could rise by about 0.3 percentage points compared to earlier forecasts. Under this scenario, the Bank of England might overlook the temporary spike, potentially keeping interest rates steady.
However, the second scenario paints a more concerning picture. Should energy prices remain high for an entire year, CPI inflation could increase by 0.7 percentage points in 2026 and a further 0.5 percentage points in 2027. This protracted rise could also dent the UK’s gross domestic product (GDP) by 0.2 points in 2026 and 0.3 points the following year. In this case, interest rates might need to be adjusted upwards by about 0.8 percentage points, contradicting earlier expectations for rate cuts.
Implications for Economic Policy
Ed Cornforth, an economist at Niesr, expressed concern over the conflict’s potential economic ramifications. He noted, “The conflict in the Middle East will have material implications for the economic outlook. The Bank of England will have to contend with a shock to global energy prices, with the question of persistence hanging over their heads.”
He also pointed out that increased financing costs could exacerbate the already fragile fiscal situation, particularly affecting shadow Chancellor Rachel Reeves. Rising interest rates would complicate government borrowing and spending plans, further straining public finances.
Why it Matters
The prospect of rising interest rates due to fluctuating energy prices poses a significant challenge for UK households and businesses alike. If rates push above 4%, many consumers could face higher mortgage payments and increased costs of borrowing, impacting their disposable income and spending power. As the Bank of England grapples with these challenges, the broader economic stability of the UK hangs in the balance, with everyday citizens bearing the brunt of these geopolitical tensions.
