The Bank of England has raised its benchmark interest rate from 3.75% to 4%, as higher energy prices linked to the Iran war intensify inflation risks and tighten global oil and gas supplies.

Eight members of the Monetary Policy Committee backed the quarter-point increase, the first since August 2023. One member voted for a larger, half-point rise.

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Energy Prices Renew Inflation Concerns

UK inflation reached an 11-month high of 3.5% in September, well above the Bank’s 2% target. Rising energy costs have heightened concerns that price pressures could persist and prompt further rate increases in 2027.

Although there is still limited evidence of higher energy costs feeding through into other prices and wages, policymakers warned that inflationary pressures were building. Economic growth, meanwhile, is expected to slow in the coming quarters.

“The longer energy prices remain elevated, the greater the risk that a temporary price shock becomes more permanent,” said Ellie Henderson, an economist at Investec.

Inflation Could Reach 5% In 2027

In its latest quarterly forecasts, the Bank warned that inflation could approach 5% by mid-2027 as higher energy costs feed into household and business bills.

At the same time, its growth outlook improved. UK economic expansion is now forecast at 1.6% this year and 1.3% in 2027, compared with previous estimates of 1.1% for both years.

Further Rate Increases Remain Possible

Bank of England Governor Andrew Bailey stressed that the latest increase did not signal an automatic series of rate rises. However, further tightening remains possible if the conflict in the Middle East continues to push energy prices higher.

“The MPC will judge the outlook at each meeting, responding as necessary to bring inflation sustainably back to our 2% target,” Bailey said.

Financial markets have already adjusted to the changing outlook. Benchmark two-year mortgage rates have risen by nearly half a percentage point since early September. According to the Bank’s latest Market Participants Survey, the median expectation was for the benchmark rate to reach 4% in November and 4.25% in February.

Budget Measures May Ease Inflation But Weigh On Growth

Budget measures are expected to reduce inflation by 0.25 percentage points by the second quarter of 2027. However, fiscal policy is also likely to weigh on economic growth over the medium term, according to the Bank.

The decision follows recent rate increases by the US Federal Reserve and the European Central Bank, as both institutions respond to inflation risks associated with the Iran war. Their next policy moves will largely depend on how energy prices develop.

Before the US and Israel launched strikes against Iran on February 28, UK interest rates had been declining from a 15-year high of 5.25%. The latest increase highlights how the energy shock has changed the monetary policy outlook, making the return to the Bank’s 2% inflation target more challenging.