The Bank of England is set to announce its latest interest rate decision on Thursday at 19:00 Beijing time, with widespread expectations that it will hold the bank rate at 3.75%. However, energy price shocks stemming from the Iran conflict are intensifying the debate among policymakers and investors over whether a hike is warranted. Market participants are particularly focused on whether the Bank will signal that surging energy costs could force it to match the Federal Reserve's tightening trajectory. On Wednesday, the Fed raised rates by 25 basis points, marking its first increase since 2023, while hinting at additional moves ahead. The Fed cited persistent inflationary pressures, partly driven by higher energy costs related to the conflict in Iran, as justification for the decision. The European Central Bank also announced its second rate hike of the year last week, following its first increase in three years back in June. Meanwhile, the Bank of Japan is expected to raise its key rate on Friday when it concludes its two-day meeting. If the Bank of England holds steady on Thursday, it will diverge markedly from other major central banks. A survey conducted last week showed that a majority of economists expect the Bank of England to keep the bank rate at 3.75% for the remainder of the year. Of the nine Monetary Policy Committee (MPC) members, only three are projected to vote in favor of a hike this week. Financial markets were pricing in roughly an 80% probability on Wednesday that the Bank would implement a 25 basis point hike in November, potentially the first of about four increases over the coming year. However, economists are significantly less convinced than markets, with only about one-eighth of survey respondents predicting a November move. So far this year, the Bank of England has left its key rate unchanged, with the last adjustment occurring in December when it cut rates by 25 basis points.

Inflation climbs to 3.1% as energy costs pressure the UK again

Data released on Wednesday showed that UK inflation rose to 3.1% in August, the first time it has breached the 3% threshold since March. The Office for National Statistics stated that the jump was primarily driven by a surge in motor fuel costs, which soared by 23% year-on-year. As a net energy importer, the UK is especially vulnerable to external energy shocks and is still dealing with post-pandemic inflation and the cost-of-living crisis stemming from the impact of the Russia-Ukraine war on natural gas supplies. Both UK natural gas and Brent crude futures have climbed nearly 20% this month, an unwelcome development for an economy heavily reliant on imported energy. If energy prices continue their upward trajectory, they will push inflation, already at 3.1%, further above the Bank of England's 2% target. Over the past five years, UK inflation has remained above target for most of the period, with only three months below it. Allan Monks, economist at JPMorgan, expects the Bank to hold steady this week to avoid amplifying market expectations for a rapid tightening cycle, while still anticipating a rate hike at the November meeting. In a note to clients, he argued that given energy price trends pointing to inflation peaking at 3.9% in February, there is a clear rationale for the Bank not to delay hikes any further. However, others remain less certain, emphasizing that the labour market is cooling and that elevated market rates are already tightening financial conditions on behalf of the central bank. Analysts at Evercore ISI, an investment advisory firm, noted that the gap between market pricing and policymakers' expectations is most pronounced in the UK, pointing out that rate markets anticipate approximately 4.5 hikes over the next year, while Bank leadership still hopes to navigate this period without raising rates. Governor Andrew Bailey told reporters at the previous rate meeting: "Please don't leave this room thinking the Bank of England is heading toward rate hikes." Franklin Templeton, a US asset manager, indicated on Wednesday that UK government bonds look particularly attractive in this environment, as labour market cooling and a softer economic outlook suggest the Bank's policy will be more accommodative than market pricing implies.

UK bonds and quantitative tightening plans in focus

Investors in UK government bonds are also awaiting the Bank of England's annual update on Thursday regarding its plans to shrink its balance sheet through the sale of government debt. Reports on Tuesday suggested the Bank would halt sales of 20-year and 30-year gilts, which have been heavily affected by the global sell-off. Such a move could provide Chancellor John Healey with some fiscal breathing room as he prepares to deliver his first budget statement on October 28. Reports further indicated that the Bank could go beyond that by halting all secondary market sales of UK gilts, instead transferring them to the government's Debt Management Office (DMO), which would then count the equivalent amount against its own financing remit. Peter Schaffrik, rates strategist at RBC, noted that this would make the DMO the sole supplier of UK gilts to the market, giving them complete control over bond issuance strategy. Global inflation concerns, political instability, and worries over UK fiscal policy have weighed on British government bonds throughout this year. The UK currently has the highest borrowing costs among G7 nations, with yields on its 20-year and 30-year long-dated gilts nearing 6%. Shreyas Gopal, FX strategist at Deutsche Bank, said in a Wednesday report that the lack of any substantial hawkish surprise in this week's UK labour market and inflation data was sufficient to cause another pullback in pricing for a hike at this meeting. Markets are now closely monitoring the Bank of England's statement on Thursday, the MPC voting split, and the latest details of its quantitative tightening programme. These elements could determine whether bets on a November rate hike continue to build or start to fade.