29th July 2026
The Bank of England has been trying to bring interest rates down while keeping inflation under control. The latest oil-price shock could make that balancing act considerably more difficult.
The Bank is expected to leave Bank Rate at 3.75% at its meeting on Thursday, but the outlook beyond that has become much less certain.
The reason is simple: oil prices have risen sharply again.
Brent crude briefly moved above $100 a barrel before falling back, and the possibility of another sustained energy shock has caused financial markets to reconsider the path of UK interest rates.
The Bank therefore faces an awkward choice.
Should it keep rates high to prevent another inflation problem?
Or should it reduce rates to support an economy that is already showing signs of weakness?
The good news is that inflation has fallen
The latest ONS figures showed CPI inflation falling from 2.8% to 2.6% in June.
That was considerably better than many feared.
Core CPI also remained at 2.6%, while services inflation eased from 3.7% to 3.6%.
This gives the Bank some reason to believe that the underlying inflation problem is gradually improving.
It also explains why an immediate rate increase is not expected.
But oil has changed the picture
The difficulty is that the June inflation figures partly reflect a period when energy prices were more favourable.
Oil has since become much more volatile.
If higher oil prices persist, they will eventually feed into transport and other business costs.
The Bank then has to consider whether this is simply a temporary energy shock or whether it will become embedded in wider inflation expectations.
That distinction is critical.
A temporary jump in petrol prices doesn't necessarily require higher interest rates.
But if businesses begin raising prices across the economy and workers demand higher wages to compensate, the Bank has a much bigger problem.
The Bank cannot control the price of oil
This is perhaps the most frustrating part of the situation.
Higher interest rates cannot produce more oil.
They cannot reopen the Strait of Hormuz.
They cannot end the Iran conflict.
And they cannot directly reduce the cost of imported energy.
What higher interest rates can do is reduce demand elsewhere in the economy.
That can prevent an energy shock from spreading into a wider inflation problem.
But doing so comes at a cost.
Higher rates hurt borrowers
For households, higher interest rates can mean:
more expensive mortgages;
higher costs when refinancing;
more expensive loans;
greater pressure on household budgets.
For businesses, the consequences can include:
higher overdraft costs;
more expensive investment finance;
reduced expansion;
delayed equipment purchases;
weaker demand from customers.
That is particularly important for small businesses, where borrowing costs can have a direct impact on cash flow.
The Bank therefore faces a contradiction
The economic problem can be described very simply.
Oil prices rise → inflation rises.
But:
Interest rates rise → economic growth weakens.
The Bank therefore risks making the economy weaker in an attempt to prevent higher inflation.
That is why economists are increasingly discussing the possibility of stagflation.
Britain is not necessarily experiencing stagflation in its full sense.
But the combination of higher energy costs, persistent inflation and weaker growth is moving in that direction.
The labour market adds another complication
The Bank also has to consider employment.
NIESR expects the UK unemployment rate to reach around 5.3% in early 2027.
If unemployment rises while economic growth slows, the case for cutting interest rates becomes stronger.
But if inflation is simultaneously moving upwards because of energy prices, the case for cutting becomes weaker.
The Bank is therefore being pulled in opposite directions.
What are markets expecting?
Markets have become considerably more cautious about future rate cuts.
After the oil-price increase, interest-rate futures were pricing in a significant possibility of a quarter-point rate rise later in the year.
Reuters reported that markets had moved to price in roughly a two-thirds chance of a September increase, although economists were considerably less convinced that a rise would actually happen.
That difference is important.
Financial markets can change their expectations rapidly when oil prices move.
The Bank, however, has to look beyond one day's oil price.
It needs evidence that higher energy costs are feeding into wages and underlying inflation.
What about mortgages?
This is where the Bank's decision becomes particularly important for households.
A fall in Bank Rate does not automatically mean every mortgage becomes cheaper immediately.
Many borrowers are on fixed-rate deals.
But changes in expectations about future Bank rates can influence mortgage pricing before the official rate changes.
If markets start expecting rates to remain higher for longer, new fixed-rate mortgages can become more expensive.
That means the oil price can affect household finances even before the Bank actually raises Bank Rate.
Businesses face the same problem
For businesses, borrowing costs are an important part of investment decisions.
A company considering buying new machinery or expanding premises has to calculate whether the expected return is sufficient to justify the finance cost.
Higher interest rates make fewer investments attractive.
That can reduce economic growth.
And that is why there is a danger in using interest rates too aggressively to deal with an inflation shock caused by energy prices.
The cure can weaken the economy that is already suffering from the disease.
The Bank also has to consider expectations
There is one reason why the Bank may still be concerned about higher oil prices.
People and businesses form expectations about future prices.
If households begin to believe that inflation will remain high, workers may demand larger wage increases.
Businesses may raise prices in anticipation of higher costs.
Those decisions can reinforce one another.
The Bank therefore needs to convince the public and financial markets that it will not allow an energy shock to become a permanent inflation problem.
But raising rates isn't necessarily the answer
There is an important limit to monetary policy.
If oil rises because supply has been disrupted, raising interest rates cannot fix the underlying problem.
The Bank could suppress demand sufficiently to reduce some inflationary pressure, but at the cost of weaker economic activity.
That is why the Bank's response has to be carefully judged.
It needs to distinguish between first-round effects from higher energy prices and second-round effects in wages, services and business pricing.
The Government faces the same dilemma
The Bank's problem is made more difficult by the Government's fiscal position.
NIESR says higher energy prices have eroded most of the Government's previous fiscal headroom and expects inflation to remain above the Bank's 2% target until early 2029.
At the same time, Andy Burnham's Government is considering measures designed to reduce household costs and increase spending on public services.
That creates a complicated combination.
The Government wants to support households.
The Bank may need to restrain demand.
The two policies can therefore pull in opposite directions.
So what should the Bank do?
The most likely answer is patience.
With inflation at 2.6%, the Bank has no immediate need to panic.
It can watch what happens to oil prices and, more importantly, whether higher energy costs begin feeding into wages and underlying inflation.
If oil prices fall back, the case for eventual rate cuts becomes stronger.
If oil prices remain high and inflation expectations start rising, the Bank may have little choice but to keep rates higher for longer — or even increase them.
The next few months could therefore be crucial
The Bank of England's biggest problem is that it has little control over the original source of the latest inflation risk.
It cannot determine what happens to oil prices.
It can only respond to the consequences.
That makes the coming months particularly important for:
mortgage borrowers;
businesses;
savers;
government finances;
consumers;
and the wider economy.
A fall in oil prices would give the Bank room to concentrate on supporting economic growth.
A sustained period above $100 would give it a very different problem.
Britain is caught between two economic risks
The country therefore faces two competing dangers.
Keep interest rates too high for too long: economic growth suffers, businesses invest less and households face greater borrowing costs.
Cut rates too quickly: inflation could become entrenched again if the energy shock spreads through the economy.
Neither option is particularly comfortable.
That is why Thursday's decision matters, even if the Bank simply leaves Bank Rate at 3.75%.
The more important question won't necessarily be what happens this week.
It will be what the Bank believes will happen over the next six to twelve months.
And with oil prices once again capable of moving by tens of dollars a barrel in a matter of weeks, forecasting the path of interest rates has become considerably more difficult.
The Bank of England is not simply fighting inflation anymore. It is trying to protect the economy from the consequences of an inflation shock it cannot directly control.
That may be one of its most difficult balancing acts since the energy crisis began.