Bank of England hikes to 4% as Iran war pushes UK inflation toward 5%

The Bank of England raised its key interest rate by 25 basis points to 4% on Thursday, its first hike in over three years, CNBC reported.

The widely anticipated move makes the Bank of England the last major central bank to embark on a tightening cycle since the U.S. and Israel went to war with Iran eight months ago. The majority of the Monetary Policy Committee voted for the quarter-point hike, with the motion passing 8 votes to 1. The dissenting member, Catherine L. Mann, voted to raise the rate by 50 basis points to 4.25%.

Policymakers said they now expect U.K. inflation to rise 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 in a statement.

The Iran war channel

The connection to the Iran war is explicit in the MPC’s statement. “The conflict in the Middle East is now in its ninth month,” the committee said. “Global energy prices have continued to rise from an already elevated level.”

Governor Andrew Bailey said in the November Monetary Policy Report 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 without news that softens inflationary pressures, “I can see the argument for a further increase in rates.”

The U.K. is a net energy importer, which makes it particularly vulnerable to external energy shocks. The Iran war has disrupted Middle East oil and gas supplies, pushing prices higher. U.K. consumer price inflation jumped to 3.5% in September, driven by the surging cost of motor fuels. The BoE’s forecast of 5% inflation by mid-2027 implies that the energy shock will continue to feed through to consumer prices for at least another year.

The BoE is now the third central bank to cite the Iran war as a driver of inflation in the past week. The Reserve Bank of Australia hiked to 4.85% and cited the war’s impact on fuel prices. The European Central Bank is facing 4% euro zone inflation driven by energy costs. The Bank of England’s hike completes the picture: the Iran war is causing global inflation to re-accelerate, and central banks are being forced to respond.

The dissent

Catherine L. Mann, the MPC’s most hawkish member, voted for a 50-basis-point hike. Her reasoning is worth examining because it points to a deeper concern about the inflation dynamics.

Mann said her recent votes for 25-basis-point hikes represented a “down payment” to lean against second-round effects. She argued that the economy has “crossed the estimated statistical threshold into a high inflation-tight labour market regime where the asymmetric behavioural responses of households and firms support stronger second-round effects.”

In plain terms, Mann is saying that the U.K. economy has moved into a regime where inflation is more likely to persist. When inflation is low and the labor market is loose, firms absorb cost increases rather than passing them on. When inflation is high and the labor market is tight, firms pass cost increases through to prices and workers demand higher wages to compensate. The second-round effects become self-reinforcing, and a 25-basis-point hike is not enough to break the cycle.

Mann also cited research suggesting the economy “may well have breached the policy credibility threshold, which worsens the policy trade-off.” If the public stops believing the Bank of England can control inflation, inflation expectations become unanchored, and the cost of restoring credibility is much higher. From that perspective, a 50-basis-point hike is “good policy” because it demonstrates resolve.

Market reaction

Ahead of the decision, markets had been pricing in more than a 99% chance of a rate hike, according to LSEG data. Traders were also pricing in a one-in-four chance of a further hike in December. The high probability suggests the market was not surprised by the hike, but the December pricing suggests the market expects more tightening.

Yields on U.K. government bonds, known as gilts, had been rising before the announcement and continued higher after. The yield on the benchmark 10-year gilt was 2 basis points higher at 5.1546%, while the 2-year gilt yield rose 4 basis points to 4.782%. The yield curve is inverted, with 2-year yields below 10-year yields, which typically signals that the market expects rates to fall over time. But the level of both yields is high, reflecting the market’s view that rates will stay elevated for longer.

The British pound, which hit a post-Brexit high on Wednesday, was flat against both the U.S. dollar and the euro on Thursday afternoon. The currency’s strength before the decision suggests the market had already priced in the hike. A stronger pound helps import inflation by making foreign goods cheaper, but it also hurts export competitiveness.

The global context

The Bank of England’s hike stands in contrast to the Federal Reserve, which is in a rate-cutting cycle. The Fed has been cutting since September, betting that U.S. inflation is on a sustained downward path. The BoE is hiking because U.K. inflation is on an upward path. The divergence is driven by the energy shock, which hits the U.K. harder because of its reliance on imported energy.

The BoE is also hiking alongside the Reserve Bank of Australia, which raised its rate to 4.85% this week. Two major central banks hiking while the Fed cuts is an unusual configuration. It reflects the uneven impact of the Iran war: energy-importing countries are seeing inflation rise, while the U.S., which is now a net energy exporter, is seeing inflation ease.

Scott Gardner, investment strategist at JPMorgan Personal Investing, called the hike “hugely symbolic.” He noted it is “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.” The path ahead depends on oil and natural gas prices, which have risen sharply over the past few months. Gardner warned of “tentative signs of second round inflation effects in the UK economy,” including an acceleration in goods and services inflation.

What I think

The Bank of England’s hike is the clearest sign yet that the Iran war is causing a global re-acceleration of inflation. The BoE is the third central bank in a week to cite the war as a driver of price pressures, and its forecast of 5% inflation is alarming. Five percent inflation is more than double the target, and the BoE is saying it will get there by mid-2027, which is eight months away. That is not a temporary blip; it is a sustained overshoot.

Mann’s dissent is the most important part of the decision. Her argument about second-round effects and credibility is the argument that should worry policymakers everywhere. If the energy shock feeds into wage demands and price-setting behavior, the inflation becomes self-sustaining and rate hikes become less effective. The BoE needs to break the second-round effects before they become entrenched, and a 25-basis-point hike may not be enough.

The global divergence is the thing to watch. The Fed is cutting while the BoE and RBA are hiking. That divergence cannot persist indefinitely. Either the Fed will be forced to reverse course and hike, or the BoE and RBA will be forced to stop. The outcome depends on whether the energy shock is temporary or persistent. If oil prices stay elevated because the Iran war drags on, the Fed’s rate cuts will look premature, and the divergence will narrow.

The pound’s strength is a double-edged sword. It helps import inflation, but it hurts exports. The U.K. economy is already dealing with the drag from higher rates and the cost-of-living crisis. A stronger pound adds another headwind for exporters. The BoE is betting that the inflation fight is more important than the growth risk, and the 8-1 vote shows the committee is largely united in that view. But the growth costs are real, and they will show up in the data in the coming months.