The nature of the UK’s inflation challenge has been fundamentally changed by the Iran war, as the Bank of England voted unanimously to hold rates at 3.75% on Thursday and acknowledged that the conflict had transformed the inflation problem from one of gradual domestic normalisation to one of managing an acute external shock. The monetary policy committee described the war as a significant new development that required a different analytical approach and policy response from anything the Bank had been planning just weeks before. Officials warned that inflation could rise above 3% and borrowing costs might need to increase.
The changed nature of the challenge is visible in the different characteristics of the inflation risk now facing the Bank. Before the war, the challenge was managing the final phase of a domestic disinflation process, ensuring that inflation settled sustainably at the 2% target after a period of above-target price growth. After the war’s outbreak, the challenge is responding to an externally generated energy price shock of unknown duration and severity, operating on an economy already in a fragile state.
Governor Andrew Bailey said the changed nature of the challenge had required the committee to revisit its analytical framework and its assessment of the appropriate policy response. He warned of rising energy costs and said the Bank was prepared to act if the inflationary consequences became entrenched. His communication reflected an awareness that the tools available for the new challenge were the same as before but the strategic context in which they would be deployed had shifted significantly.
Financial markets adapted to the changed challenge. UK gilt yields rose, the FTSE 100 fell, and the pound strengthened against the dollar as traders priced in the new scenario. Analysts noted that the changed nature of the challenge made forward guidance more difficult and the policy outlook more uncertain than it had been in the pre-war environment.
For the Bank’s institutional credibility, the changed nature of the challenge creates a communication task of some difficulty. Explaining to the public why inflation might rise again after a period of decline, and why the Bank might need to raise rather than cut rates, requires clear and honest communication about the external forces at work. Thursday’s decision demonstrated a willingness to be direct about the challenge, even if the specific policy response remained appropriately conditional.