The Bank of England is expected to keep interest rates unchanged at 3.75 per cent on Thursday, despite a recent rise in oil prices above $100 a barrel that could test whether it avoids raising borrowing costs in response to the US-Iran conflict.
British inflation has so far remained below the BoE's forecasts, falling to a 15-month low of 2.6 per cent in June.
Because regulated household energy prices respond more slowly to higher wholesale costs, Britain currently has lower inflation than the United States and the euro zone. In contrast, the European Central Bank is expected to raise interest rates again in September or October.
A BoE rate rise would create challenges for prime minister Andy Burnham, who has pledged to focus on reducing the cost of living. His government also faces higher borrowing costs ahead of its first annual budget in the autumn.
Economists surveyed by Reuters and financial markets do not expect the BoE to raise rates this week. However, opinions differ over what the central bank will do in the coming months.
Following last week's jump in oil prices, interest rate futures pointed to a two-in-three chance of a quarter-point BoE rate rise in September and almost three rate increases by next June.
Even after oil prices dropped to $90 a barrel on Monday, markets continued to fully price in a rate rise by November.
Only a small number of economists expect rates to increase this year.
Henry Cook, a senior economist at Japan's MUFG, withdrew his earlier forecast that the BoE would make a precautionary rate rise similar to the ECB.
"We've had three downside surprises now in a row on inflation and plenty of signs of slack within the labour market," he said.
In April, the BoE forecast inflation would peak at around 3.6-3.7 per cent at the end of 2026 under two of its three scenarios for oil prices and other economic developments. In June, it lowered that forecast to just over 3.25 per cent.
Oil futures remain in line with the mildest of the BoE's three scenarios, while the futures curve for natural gas prices, which reached a four-month high last week, is close to the middle scenario.
Even so, British inflation has remained above the BoE's 2 per cent target for most of the past five years.
BoE chief economist Huw Pill, who voted for a rate rise in both April and June, has warned that a second oil price shock in four years could lead households and businesses to expect inflation to remain higher for longer.
Governor Andrew Bailey has said the BoE does not need to raise rates in the same way as the ECB because it had cut rates by less before the Iran war began at the end of February.
British mortgage rates and business borrowing costs increased almost immediately after the BoE signalled in March that the rate cuts previously expected in 2026 were unlikely.
On Thursday, Bailey is expected to repeat that the BoE will closely monitor wage growth and price increases that are not directly linked to higher energy costs.
Although household and business inflation expectations rose sharply at the start of the conflict, more recent data, including wage figures, has provided some reassurance.
The BoE is also expected to publish an analysis of how its bond sales programme affects financial markets before the Monetary Policy Committee votes in September on the pace of those sales.
Last year, the BoE reduced the pace of quantitative tightening to £70 billion ($93 billion) a year from £100 billion and shifted sales towards shorter-dated bonds. A BoE survey in June showed markets expect QT to slow further to £50 billion.
Before last year's decision, the BoE estimated QT had added 0.15-0.25 percentage points to long-term gilt yields. Research published by the central bank in May suggested the impact was closer to 0.4 percentage points.
University of Liverpool professor Costas Milas, who co-authored the research, said the BoE might need to review the pace of bond sales but should not suspend QT altogether.
"If we just ignore QT or pause QT ... perhaps the BoE might have to raise Bank Rate earlier than it possibly has in mind," he said.
