Bank of England Raises Interest Rate for First Time Since Iran War, Warns Inflation Will Near 5%

The Bank of England raised its key interest rate by 25 basis points to 4% on Thursday, its first increase in more than three years and its first since the United States and Israel went to war with Iran eight months ago. The widely anticipated decision made it the last major central bank to embark on a tightening cycle since the conflict began.

A majority of the bank's Monetary Policy Committee backed the quarter-point increase, with the motion passing by eight votes to one. The lone dissenting member voted instead for a larger rise of 50 basis points, which would have taken the rate to 4.25%.

"The conflict in the Middle East is now in its ninth month," the MPC said in a statement on Thursday. "Global energy prices have continued to rise from an already elevated level." Policymakers said they now expected U.K. inflation to climb to about 5% by the middle of 2027. "It is then projected to fall as the impact of rising energy prices on 12-month inflation rates fades, and still restrictive monetary policy bears down on inflation," they said.

Ahead of the announcement, markets had been pricing in a greater than 99% chance of a hike, according to LSEG data. Traders also saw a one-in-four chance of a further increase in December.

In the November Monetary Policy Report, Governor Andrew Bailey warned that without "real progress towards settling the conflict in the Middle East.. risks to energy prices, and so to inflation, are to the upside." He added that, absent news that softens the risks to inflationary pressures, he could see the argument for another rate increase, followed by a more conditional approach dependent on evidence around energy prices and inflation dynamics.

Figures released earlier this month showed the U.K.'s annual inflation rate jumped to 3.5% in September, driven by surging motor fuel costs. As a net energy importer, Britain is particularly exposed to external energy shocks such as the one caused this year by the Iran war.

Catherine L Mann, the MPC's most hawkish member, said she had voted for greater tightening than her colleagues because research pointed to "non-linear inflation risks." She said her recent votes to raise Bank Rate by 25 basis points represented a "down payment" to lean against second-round effects, reinforce credibility and uphold good policy, arguing the economy had crossed a statistical threshold into a high inflation, tight labour market regime. "From a risk management and credibility perspective, a 50-basis point hike in Bank Rate is 'good policy'," she said.

Yields on U.K. government bonds, known as gilts, had been climbing before the announcement and continued to edge higher afterward. The benchmark 10-year gilt yield was last seen 2 basis points higher at 5.1546%, while the 2-year yield rose 4 basis points to 4.782%. The pound, which hit a post-Brexit high on Wednesday, was flat against both the U.S. dollar and the euro on Thursday afternoon.

Scott Gardner, investment strategist at JPMorgan Personal Investing, said in a note that the November hike was "hugely symbolic," calling it a "180-degree turn from the start of the year when many believed interest rates would come down as UK inflation had been mostly tamed." He said the path ahead remains uncertain, hinging not only on oil but also on natural gas prices, which have risen sharply in recent months. Gardner pointed to tentative signs of second-round inflation effects, including accelerating goods and services inflation, and said the bank would be wary of that while also conscious that overly aggressive rate hikes could stunt the positive U.K. economic growth seen of late.