UK inflation forecast: where are prices heading next?
With conflict in the Middle East disrupting the global economy, inflation is now expected to rise in the UK. What’s next for prices?
UK inflation is set to rise as the country grapples with the economic consequences of the Iran war and extreme weather.
Bank of England governor Andrew Bailey warned the almost complete closure of the Strait of Hormuz is forcing energy prices up further, leading to increased inflation, in a statement to the Treasury Select Committee on 8 September.
“It's obvious the conflict is still going on, and it is also causing a high level of energy prices, and also quite a bit of volatility in energy prices, and that volatility is feeding through into financial markets,” he said.
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“I think it's fair to say that we have higher energy prices. They could be higher still,” Bailey warned.
The problem could be exacerbated too as Bailey added that drought in the UK and the El Niño weather phenomenon mean the risks to inflation “are on the upside”.
“We've got this El Nino issue building up,” he said. Bailey noted, cautiously, that food price inflation has so far undershot the Bank’s projections.
“However, I think unfortunately this is another area where the risks are on the upside,” Bailey added.
The central bank’s central forecast from 30 July shows it anticipates price growth to peak at 3.2% this year before easing again.
Inflation rose to 2.9% in the year to July, up from 2.6% in June, according to the latest data from the Office for National Statistics (ONS). The rise was widely predicted by economists.
July’s inflation figure was driven by surging gas, energy, furniture, household goods, clothing, and footwear prices.
The overall increase was partially offset by a fall in transport inflation and the lowest level of food and non-alcoholic drink inflation since 2021.
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.
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.
Where do experts think inflation will go?
Most economists think inflation will remain above the Bank of England’s 2% target for the rest of 2026.
The central forecast by the Bank of England, published on 30 July (before the October price cap was confirmed), shows inflation is expected to peak at 3.2% in the final quarter of the year, mostly driven by higher energy prices.
The central bank also published two other scenarios. The milder scenario assumes higher energy prices will have less impact on inflation and show it could only peak at 3% in the final quarter of 2026.
Conversely, their worst-case scenario shows inflation could keep rising in the remainder of this year, peaking at 4.2% in the second quarter of 2027 if energy prices rise more substantially.
Meanwhile, Deutsche Bank expects inflation to peak at 3.1% this year, a little lower than the Bank of England’s central projection published on 30 July, but predicts price growth will be higher for longer than their previous forecasts thanks to higher energy and food bills.
Sanjay Raja, chief UK economist at Deutsche Bank, said: “Cost of living pressures are likely to rise from here. Energy prices have already made a comeback with pump prices in August on the rise. Further rises in the Ofgem price cap can’t be ruled out either. We also think that food inflation is approaching its nadir.”
The average forecast from economists surveyed by the Treasury on 19 August is that inflation will rise to 3.3% in the final quarter of 2026. By Q4 2027, they expect inflation will average 2.3%.
While inflation forecasts are less dire today than they were in March shortly after the Iran war began, all forecasts still expect inflation to remain above the 2% target for all of 2026 and some of 2027.
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 30 July, it was confirmed the Monetary Policy Committee (MPC) had held interest rates at 3.75% for the fifth 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.
This move was in line with most forecasts by economists, and experts believe that interest rates will stay at 3.75% until at least early 2027.
On 3 September, Pill, the Bank of England’s chief economist, reiterated his call for interest rates to be raised to 4%, saying this would signal the MPC’s willingness to address inflationary risks to the markets.
The MPC’s next base rate decision is due to be announced on 17 September.
Raja at Deutsche Bank said the July CPI data, published on 19 August, was unlikely to “move the dial too much on the MPC's thinking,” expecting them to stay in “wait and see” mode.
“That said, concerns around the inflation outlook remain. With Middle East tensions continuing to unfold, food prices likely to rise on the back of the recent hot weather, the main concern for us now is whether next year's projected drop materialises.”
