Bank of England may raise interest rates as oil shock from Middle East war raises inflation fears

Expectations for UK interest rates have shifted sharply after a rise in global oil prices fueled by escalating conflict in the Middle East, with investors now increasingly betting that borrowing costs could rise rather than fall in 2026.

Financial markets are pricing in about a 70 percent chance that the Bank of England will raise interest rates by a quarter of a point before the end of the year, a dramatic reversal from expectations two days ago when traders expected more rate cuts.

Just two weeks earlier, markets had predicted that the Bank would start reducing its base rate from the current 3.75 percent, with the first cut expected at the Monetary Policy Committee meeting scheduled for March 19.

Instead, the escalating war involving Iran, Israel and the United States has dramatically changed the economic landscape by sending energy prices skyrocketing and threatening a new surge in global inflation.

The change in interest rate expectations is primarily driven by the rapid increase in oil prices following disruptions in shipping lanes through the Strait of Hormuz.

International Brent crude oil rose nearly 30 percent during the day, trading briefly below $120 a barrel, its highest level since the 2022 energy crisis.

At the same time, US benchmark West Texas Intermediate crude oil posted its biggest weekly gain on record as traders feared prolonged disruptions to global energy supplies.

The Strait of Hormuz. which carries one-fifth of the world’s oil exports, has been effectively closed to regular commercial shipping following Iranian threats to target vessels using the route.

Energy traders warn that further disruptions could lead to continued shortages of oil and gas on global markets.

While rising oil prices pose a risk of global inflation, the UK economy is considered particularly vulnerable due to its heavy reliance on imported natural gas to heat homes and generate electricity.

Wholesale fuel prices in Britain have already risen due to the conflict, raising concerns that domestic energy bills could rise again later this year.

Industry analysts have warned that the price of energy in the UK could rise by up to £500 over the summer if higher fuel prices continue.

Higher energy costs may feed into transportation, food production and manufacturing chains, driving inflation even higher.

Economists at Deutsche Bank predict that UK inflation could reach 4 percent by the end of 2026, double the Bank of England’s 2 percent target if the conflict continues to disrupt energy markets.

The sudden change in expectations caused a major upheaval in UK government bond markets.

The yield on the 10-year benchmark, a key measure of government borrowing costs, rose about 0.4 percent in the week to 4.74 percent, marking the biggest increase in major advanced economies.

Bond yields rise when investors sell government debt, reflecting expectations of higher inflation or tighter monetary policy.

Analysts said the move represented the biggest sell-off in UK bonds since the financial crisis caused by the “minimum budget” for 2022 announced by Prime Minister Liz Truss.

Short-term borrowing costs have risen very quickly. The yield on two-year gilts, which are more sensitive to interest rate expectations, rose 0.25 percent in one trading session.

The rapid devaluation of financial markets reflects the view that central banks may now have to keep monetary policy tight for longer to contain inflationary pressures.

Dario Perkins, head of macro global at the economic consultancy TS Lombard, said the oil shock has fundamentally changed the outlook for interest rates.

“Inflation is already exceeding targets and, in the minds of policymakers, that makes expectations fragile,” he said. “For now, all price cuts have been postponed.”

The change is not limited to the UK. Investors are also beginning to discount the possibility that the European Central Bank may raise interest rates later this year, reflecting the eurozone’s greater reliance on foreign currency.

Major banks around the world are now reassessing the economic impact of the Middle East conflict.

Next week both the ECB and the Federal Reserve will announce their latest interest rate decisions.

Speeches from ECB president Christine Lagarde and Federal Reserve chairman Jerome Powell are expected to focus heavily on how the oil shock may affect currency, economic growth and interest rate policy.

The United States says it is immune to global energy price shocks thanks to its large domestic shale oil industry, even though fuel prices have already risen to their highest levels since mid-2024.

A change in expectations has begun to seep into the UK housing market, with lenders adjusting house prices in anticipation of higher borrowing costs.

Banks and building societies base loan rates on the financial market’s expectations of future interest rate movements, especially in volatile markets.

Several major lenders have begun raising rates on new home loans.

Nationwide Building Society increased some of its mortgage products by 0.25 per cent last week, while HSBC and Coventry Building Society confirmed similar increases would follow.

High mortgage rates may slow the housing market just as it begins to recover from the turmoil caused by rising borrowing costs in recent years.

The potential impact of continued energy price hikes extends beyond monetary policy.

Economists warn that higher fuel costs could increase food prices, especially if the supply of fertilizers is disrupted by the closure of shipping lanes in the Persian Gulf.

If oil and gas prices remain high for long, the resulting inflationary pressures may force central banks to maintain tighter monetary conditions as economic growth weakens.

For policymakers at the Bank of England, the challenge is becoming increasingly clear: balancing the need to control inflation while avoiding further damage to an already fragile economy.