Energy and food price pressures intensify, potentially triggering an inflation rebound! The Bank of England may struggle to remain "calm" as market rate hike bets surge

According to Zhitong Finance APP, following July’s rate decision, Bank of England Governor Andrew Bailey gave reporters an unusually candid message: “Please don’t leave this room thinking the Bank of England is on a path to raise rates.” But with this Thursday’s latest rate decision, he may find it difficult to be so unequivocal.

Surging energy price pressures brought by the unresolved Middle East conflict are mounting—Brent oil prices have firmly stood above $100 per barrel, and gas costs pose an even greater challenge for the UK. Bailey recently told lawmakers that energy prices “could climb even higher.”

New risks are also looming, which could keep inflation above the Bank of England’s 2% target for most of next year. Amid widespread drought in the UK and the impending impact of a powerful El Niño event, risks to food costs are also coming into focus. Other items in the consumer basket are similarly concerning, such as airfares. Rapid economic growth also indicates that demand is stronger than anticipated.

St James's Place Chief Economist Hetal Mehta commented, “Energy prices have, to some extent, handed the baton to food prices. The broader impact of El Niño is likely to make inflation more stubborn next year. Even if energy price inflation related to the Middle East conflict recedes, you’ll see another wave of food price increases—which is exactly why the headline data won’t decline significantly.”

Traders are ramping up bets on Bank of England rate hikes

With inflation risks intensifying, the market has responded accordingly. In the days after Bailey’s July press conference, traders were pricing in less than a full 25 basis point rate hike by year-end; by September 11, they had priced in 46 basis points of rate hikes by year-end, and are betting on up to four hikes by next summer.

Most Bank of England officials believe that a weak labor market and the expected growth slowdown in the second half of the year will help rein in the price pressures resulting from the Middle East conflict. While July’s GDP data suggested the economy may be resilient, the overall evidence supports the view that secondary effects remain manageable.

Currently, there are few signs that inflation is becoming entrenched. The Bank’s August inflation expectations survey (released last Friday) showed one-year inflation expectations fell to 3.2% from 4% in May; expectations for the following 12 months dropped to 2.9% from 3.5%. A Bank of England survey of business agents nationwide found that wage settlements in 2027 are expected to be “broadly in line with or lower than 2026”—with an average increase of 3.6% in 2026.

A key domestic unknown for the UK is whether the strong economic growth in the first half of the year can be sustained, or even encourage businesses to resume hiring. Although forecasters expect persistent inflationary pressures to weigh on consumers and economic activity, surveys show that since Andy Burnham became Prime Minister in July, both consumer and business confidence have picked up, potentially boosting demand.

Rising energy bills are pushing up UK inflation again

However, the Bank of England may eventually need to change course. Oxford Economics estimates that UK inflation—currently at 2.9%—may rise to nearly 4% around the end of the year. That would be double the Bank’s target and above the level at which the central bank believes households begin to notice prices accelerating.

One key driver will be the UK’s energy price cap—the limit on what suppliers can charge consumers per unit of energy. The UK’s energy regulator Ofgem has announced that this cap will reach a three-year high in October, and experts believe it could rise further by early 2027.

Andrew Goodwin, Chief UK Economist at Oxford Economics, said: “We think the impact of the Middle East conflict is still building. We expect the price cap could rise another 13% in January. Current wholesale electricity prices are well above the level during the last observation window.”

The food sector is also warning that rising energy costs, the impact of the UK’s hot weather on harvests, and El Niño combined will increase grocery bills for much of next year. The Food and Drink Federation (FDF) expects food inflation to jump to nearly 4% before Christmas, peaking at 6.4% in July 2027.

FDF Chief Economist Liliana Danila said: “The biggest risk is what happens to commodities, and then how El Niño will impact.” She noted that crops such as cocoa, coffee, palm oil, rice, and sugar could be affected: “We could see worse outcomes than anticipated… although so far we haven’t yet seen real effects at the operational level.”

UK food inflation is expected to reach its highest since early 2024

Most economists expect the Bank of England’s Monetary Policy Committee (MPC) to vote 6-3 this Thursday to keep the rate unchanged at 3.75%. Matt Swannell, Chief Economic Adviser at ITEM Club, said the committee is likely to “strike a hawkish tone to showcase its readiness to fight inflation, in order to avoid any unnecessary loosening of financial conditions.”

In addition, it is widely anticipated that the MPC will slow the pace of unwinding its government bond portfolio, in light of the fragile state of the bond market. Since starting quantitative tightening in 2022, the BoE’s holdings of government bonds have declined from £875 billion to £489 billion. Markets expect the bank to slow the pace of unwind from £70 billion over the previous 12 months to £50 billion over the 12 months starting in October.