The Bank of England may not need to raise interest rates in response to the Iran war, governor Andrew Bailey has said in a speech in Iceland.
Bailey told the Reykjavik Economic Conference that inflation is “likely to go higher” as a result of the conflict in the Middle East, but that policymakers could look past those price rises.
The rate-setting Monetary Policy Committee could ignore higher prices if they do not filter through into wage bargaining and household expectations, he said.
“Monetary policy generally looks through the direct effects of energy prices on inflation,” Bailey said, explaining that rate rises could cause unnecessary volatility in both inflation and economic activity.
The remarks are among Bailey’s most dovish since the outbreak of the Iran war prompted the closure of the vital Strait of Hormuz shipping lane.
The governor and other central bank officials had previously signalled that the Bank of England was likely to raise its central interest rate if the Middle East conflict stretched over several months.
Despite the closure of the Strait entering its fourth month, Bailey said a hike to the Bank Rate may not be needed because of the weak domestic outlook for the UK economy.
“Continued weakness in the UK activity and the labour market is likely to lessen the strength of second-round effects from higher energy prices,” he said, while acknowledging that persistent energy price rises could strengthen those effects.
Bailey told delegates that protracted erosion of the British labour market, which has seen job vacancies hit a five-year low and unemployment reach five per cent, makes a wage-price spiral unlikely.
Monetary policy officials are particularly wary of energy price shocks becoming embedded in an economy, as they can lead employees to bargain for higher wages or seek better-paying jobs elsewhere.
This scenario, known as second-round effects, can develop into a wage-price spiral, forcing employers to raise wages after a price shock in order to retain staff, which can further push up prices.
Bailey also argued that the Bank of England had already effectively tightened monetary policy through a shift in its communications since the Strait of Hormuz closure.
Before the war, financial markets and mortgage providers had priced products on the assumption that the central bank would deliver three 0.25 per cent rate cuts over the course of 2026.
By taking those cuts off the table, the Bank of England forced private lenders to withdraw loan products offered at the start of the year and reprice them at higher rates.
He added: “We have already tightened policy considerably in response to the shock relative to what had been expected by markets. That is already affecting the economy. Key quoted rates on mortgages have increased since the onset of the conflict.”