UK inflation forecast: where are prices heading next?

UK inflation is set to rise as the country grapples with the economic consequences of the Iran war and extreme weather.

Soaring energy and motor fuel prices are pushing inflation up, with the Bank of England now predicting price growth could reach 4% next year.

Inflation rose to 3.1% in the year to August, up from 2.9% in July, according to the latest data from the Office for National Statistics (ONS). The rise was widely predicted by economists.

Try 6 free issues of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The sector that contributed the most to the rise was transport. This includes motor fuel prices, which have reached the highest level since 2022 as a litre of petrol now costs around 172p, up almost 40p since the Iran war began.

Some of the rise was offset by a fall in furniture and household good prices and clothing and footwear prices.

Why are prices rising?

Since 28 February, the Iran war has consistently disrupted global trade, leading to price increases.

One particularly damaging issue is the closing of the Strait of Hormuz, a narrow waterway between Iran and Oman through which around 20% of the world’s oil and gas is transported. This means some ships have now been stuck in the strait for over half a year.

As the strait has shut off a large proportion of the oil and gas supply, oil prices have surged, impacting motor fuel and heating oil prices. As oil is used in the production of a significant portion of the things we use and buy every day, price shocks will likely be felt more widely.

As long as the Iran war continues, prices are expected to remain high.

The energy market is also under pressure because of the war, pushing up the cost of energy for millions of households and businesses in the UK.

The Ofgem energy price cap, which dictates the maximum a supplier can charge for a unit of energy, rose at the start of July, bringing the annual household bill for a dual-fuel household paying by direct debit to £1,663.

The price cap will rise by an additional 4% on 1 October to £1,723 per year, and some forecasters, like EDF and Bloomberg Economics, predict it could rise by as much as 25% in January.

The UK is particularly sensitive to the wholesale energy market because it is a net importer of energy from overseas, meaning it is left at the whim of the market to set prices.

Even firms that do not produce goods derived from oil and gas markets will likely need to hike prices as the costs associated with running the business (such as energy bills and transportation costs) are still exposed to those markets.

These costs will likely be passed on to the consumer, although the Bank of England said that they have not seen strong evidence of this happening so far.

Where do experts think inflation will go?

Most economists think inflation will remain above the Bank of England’s 2% target for at least the rest of 2026 and probably into 2027.

The Bank of England expects inflation to increase to around 3.75% in the fourth quarter of 2026, according to their latest estimates from 18 September.

The rise in inflation will largely be driven by increased energy and fuel prices. The Bank’s analysis showed of August’s 3.1% inflation rate, around 0.7 percentage points was the direct effect of energy prices, mostly motor fuels.

This is set to get worse according to the central bank. In the minutes of the latest MPC meeting, the committee said: “Based on energy prices as at close of business on 14 September, the direct contribution of energy prices to inflation was expected to increase over coming quarters, reflecting recent further increases in wholesale oil, gas and electricity costs.

“Ofgem’s headline energy price cap for October to December would be increased to £1,723, somewhat higher than expected at the time of the July Report, and the cap was now expected to rise substantially further in 2027 Q1, all else equal.”

The committee think this will culminate in inflation edging up to 4% in the first quarter of 2027.

Additionally, while food inflation has been unexpectedly low recently, it may start to pick up in the next year due to high energy inflation, the impact of drought in Europe, and the potential impact of the El Niño weather event.

Deutsche Bank agrees that inflation is likely to rise in the coming months, also expecting it to reach around 4% by the start of 2027.

Sanjay Raja, chief UK economist at Deutsche Bank, said: “Inflation is on the ascent with an unknown destination. Events in the Middle East continue to add to inflationary pressures. On our estimates, the upcoming Ofgem price cap is due to rise by over 20% in January.

“Food prices, whilst weak today, remain poised to rise on the back of the recent heatwaves, droughts, and a potential El Niño event. For the Bank of England, its job to keep inflation at 2% has become harder. Our own projections point to CPI on course to get close to 4% around the turn of the year.”

The average forecast from economists surveyed by the Treasury on 19 August is that inflation will rise to 3.4% in the final quarter of 2026. By Q4 2027, they expect inflation ease to an average of 2.3%.

The next set of inflation data will be released by the Office for National Statistics (ONS) on 21 October.

What’s the link between inflation and interest rates?

Inflation above the 2% target is always a cause for concern for economists, policymakers and consumers.

The Bank of England is particularly focused on inflation, as it has a remit to ensure prices do not spiral out of control.

This is largely done through setting interest rates, which are typically raised to fight inflation.

The trade-off to fighting inflation with higher interest rates is reduced economic activity. When interest rates are high, people have to use more of their earnings on expenses like their mortgage and are incentivised to save their cash as savings rates tend to be higher.

What does the inflation outlook mean for future interest rate cuts?

With inflation expected to stay significantly above the Bank of England’s target, interest rates are unlikely to be cut any time soon.

On 17 September, the central bank’s Monetary Policy Committee (MPC) held interest rates at 3.75% for the sixth consecutive meeting. The motion passed by six to three.

The three members who did not vote with the majority (Huw Pill, Megan Greene, and Catherine L Mann) called for a rate hike to 4% as a preventative measure against the potential for more severe second-order inflationary effects.

They represent a growing cohort of the MPC that are becoming more vocal that the MPC should increase interest rates rather than remaining in a “wait-and-see” position.

Most economists believe interest rates will remain at 3.75% until at least early 2027, but the chances of a rate hike are growing, according to Deutsche Bank.

Raja said: “We expect the MPC to remain on hold for the remainder of the year. But as we’ve expressed recently, our conviction levels around this call have fallen.

“Policy rules all point to some modest tightening given the upward pressure on inflation. Wage pressures may also be firming a touch. Some fiscal easing looks likely in the coming Budget. We will be watching closely where pay settlements land in the coming months.

“Further out, we tweak our forecast for rate cuts next year. We no longer expect the BoE to resume any rate cuts until 2028, with the path to nominal neutral likely to take longer than we previously anticipated.”

The MPC’s next base rate decision will be announced on 5 November.