The Bank of England is navigating what some analysts are beginning to describe as an emerging stagflation risk for the UK economy, voting unanimously to hold rates at 3.75% on Thursday as the Iran war’s energy price impact threatens to push inflation higher while the domestic economy shows clear signs of weakening. The monetary policy committee warned that the US-Israel conflict against Iran could drive inflation above 3% and require rate hikes, even as unemployment has risen to 5.2% and wage growth has slowed. This combination of rising prices and slowing growth is the classic definition of stagflation.
Stagflation is notoriously difficult for central banks to manage because the tools available to fight inflation — higher interest rates — typically worsen the growth and employment picture. The Bank faces this dilemma acutely: raising rates to combat energy-driven inflation could further depress an already weakening labour market and reduce economic activity. Holding rates risks allowing inflation to become entrenched above target.
Governor Andrew Bailey did not use the word stagflation in his public communications, instead focusing on the Bank’s commitment to the 2% inflation target and its readiness to act if necessary. He acknowledged the weakness in the domestic economy through the labour market data but said the energy price risk from the war was the dominant consideration at this stage. The Bank’s response was to hold and wait for more information.
Financial markets moved to price in rate hikes regardless of the growth concerns. UK gilt yields rose, the FTSE 100 fell, and the pound strengthened against the dollar as traders focused on the inflation risk rather than the growth outlook. Analysts noted that the Bank’s communication had been more hawkish than neutral, suggesting that fighting inflation would take priority over supporting growth.
For UK households, the stagflation risk scenario is the worst of all possible worlds: higher prices, rising unemployment, and potentially higher borrowing costs simultaneously. The government faces a similarly challenging situation, with its growth agenda under pressure from multiple directions. The Bank’s next meeting will be an important indicator of whether it prioritises inflation fighting or growth support in its policy decisions.
