Bank of England sounds warning of interest rate hikes ahead

Inflation could rise to 6.2% next year, with interest rates peaking at 5.25%, in the event of a prolonged energy shock with oil prices remaining above $130 a barrel, according to a worst-case scenario modelled by the Bank of England.

The good news is that these chilling numbers are not a forecast, and the Bank's key rate-setting body has not indicated if it thinks it likely to occur.

It is just one of three potential scenarios mapped out as a "thought experiment" to help the monetary policy committee (MPC) work through different paths for the length and severity of the energy price shock triggered by the US-Israeli war on Iran.

Money latest: Reaction to Bank of England inflation and rate forecasts

The bad news is that under all three scenarios, inflation and interest rates will rise this year and Brent crude oil prices had already reached $126 a barrel before the committee's decision was announced.

In voting to hold rates at 3.75% for now, the Bank is reflecting the immediate impact on consumers but the MPC has effectively endorsed the market assumption that rates will rise by at least 0.5 percentage points this year.

The direct inflationary impact of the war is so far confined to a heavy hit at petrol and diesel pumps but the "second-round effects", on domestic energy bills, food prices and wage demands, are yet to crystallise.

"We think this is a reasonable place given the situation of the economy and the unpredictability of events in the Middle East," said Bank governor Andrew Bailey.

The key question is what happens next, once the Bank has attempted to answer by mapping out three scenarios for the market-implied rate of inflation and interest rates based on different paths for energy prices.

Under Scenario A, the peak and duration of the price shock is modest, with oil prices peaking around $110 a barrel and falling back below $80 before the end of the year and staying there. In that scenario, inflation would peak at 3.6% this year, still higher than the current 3.3%.

Under Scenario B, with oil staying above $80 a barrel, inflation would peak slightly higher at 3.7%, with a larger contribution of second-round effects, particularly from food inflation.

Under both scenarios GDP weakens to around 0.5% by the start of next year before recovering.

Scenario C is far scarier and may have looked even more extreme when the forecast period closed on 22 April than it does this morning. Under this scenario, oil prices remain above $120 a barrel for the rest of this year, a mark already passed this morning.

One positive is that the Scenario C gas price of more than 200p a therm is far higher than the current rate of around 117p a therm. The MPC highlights the lower price of gas as a key difference, with the last energy-fuelled inflation spike that followed the Russian invasion of Ukraine, when CPI rose above 11%.

Whichever of these three scenarios proves closest to reality, there is no outcome close to the pre-war position set out in February, when inflation was forecast to fall back to 2% by the end of this year, with rates following them down.

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