Persistent energy shock shifts inflation outlook
Over the last fortnight, both the US Federal Reserve and the European Central Bank raised their benchmark interest rates by 25 basis points, the latter for the second time this year. Their decisions primarily reflect domestic price pressures but also highlight the growing concern among central banks that higher energy costs could last longer and intensify inflationary pressures.
The conflict in Iran remains far from a stable or meaningful resolution. Earlier hopes that diplomacy, alternative export routes and a partial reopening of the Strait of Hormuz would restore supply and lower oil prices have proved too optimistic. The International Energy Agency has now pushed back its expectations of a normalisation in energy trade through the Persian Gulf to 2027.
Oil flows through the Strait of Hormuz remain around a third of their pre-war levels. Meanwhile, a recent drone attack has closed Saudi Arabia’s East–West pipeline, removing an important route for bypassing the Strait and moving crude to the Red Sea. Strategic stockpiles, which helped cushion the supply shock at the onset of the war, are significantly depleted and have limited capacity to blunt the effects of any further escalation in the conflict.
Therefore, the price of Brent crude oil recently rose above $100 per barrel and futures prices for the coming months have risen sharply over summer break. Current futures pricing suggests crude oil prices could average around $90 per barrel in spring 2027, a 14% uplift in expectations since August.
Beyond the price of crude oil, impairments to refining capacity in the Middle East and Russia are also pushing up prices of refined petroleum products. In addition, reduced LNG shipments from the Gulf and lower than usual European gas stockpiles risk sharply higher gas prices in the event of further supply disruptions or an unusually cold winter.
The overall impact of these is an upward revision in inflation expectations. Higher energy prices have already led to an acceleration in headline inflation. Recent developments mean Ofgem’s energy price cap will rise by 4% in October and likely increase further in early 2027. We now expect UK inflation to peak at about 4% in the first quarter of 2027 and, despite slowing thereafter, remain around 3% well into autumn.
So far, there is little evidence that the energy shock is feeding into broader price pressures. Core inflation, which strips out energy and food prices, remains steady. The proportion of goods and services in the inflation basket that have seen a recent acceleration in pricing also points to limited spillovers from higher energy prices. And the labour market continues to soften. With vacancies declining and pay growth slowing, the economy seems far from a wage-price spiral.
Yet, persistently higher energy prices do risk entrenching price pressures. They will coincide with a boom in AI investment that is driving up chip prices across the supply chains for a wide range of goods. Alongside that, fertiliser shortages earlier in the year and the El Niño weather pattern are disrupting global agricultural yields and will feed through to higher food prices in the medium term. Together, these factors could result in continued upward pressure on prices.
This presents a challenging situation for the Bank of England. It can do nothing to address the fundamental causes of higher energy or food prices but will want to guard against the risk of these supply-driven price rises spilling over to other goods and services. That will mean convincing consumers and businesses that it will not tolerate above-target inflation for long.
Markets expect that to entail four 25-basis-point rate rises by the Bank between now and the end of 2027. Before the conflict began, investors were pricing in rate cuts this year.
Higher energy prices for longer will likely drive the Bank of England to tighten policy. Western central banks were late to respond to the post-pandemic spike in inflation and the Bank of England was no exception. This time, it will be careful not to wait too long for evidence of widening price pressures before it acts. But it is also conscious of the long lags in the pass-through of previous rate rises, the impact of which many households will experience via higher mortgage payments only over the coming years.
The Bank's messaging points to a careful balancing of the economic costs of leaning too little on potential inflationary pressures against that of leaning too much. We anticipate only limited tightening, rather than the series of rate rises currently priced by markets.
Chart of the week
An ageing and declining population has driven a steady rise in the number of vacant dwellings in Japan. The latest official statistics show that there were approximately nine million vacant homes in 2023, a record high and nearly 14% of Japan’s total housing stock. By comparison, just under 4% of homes in England are vacant.
Japan’s fertility rate has remained below the population-sustaining level since 1975. This, alongside limited migration, by advanced economy standards, and rising life expectancy has resulted in Japan’s median age almost doubling since the 1960s. Its population has also declined by about 4.5% from its peak in 2010. That has reduced demand for housing, especially in rural areas and elderly neighbourhoods where younger generations inheriting property do not wish to live.
The high cost of renovating old properties to meet earthquake and energy-efficiency standards inhibits redevelopment. Lower tax rates for residential land with a building on, despite its condition, also reduces the incentive to demolish old houses. As a result, almost half of vacant dwellings in Japan are not listed for rent or sale, resulting in a growing number of derelict properties.
To combat rising vacancy rates and the accompanied economic decline, the national government has adjusted tax legislation to weaken the incentive to leave houses abandoned. Some local governments have created online databases of abandoned homes to facilitate sales at a low price, or in some cases, for free.
What we're looking out for this week?
On Thursday, US president Donald Trump will welcome Chinese president Xi Jinping on a Chinese state visit to Washington. This marks the second meeting between the two leaders this year, following Mr Trump’s visit to Beijing in May. The summit comes at a time of elevated tensions between the US and China on multiple fronts including AI, tariffs, Taiwan and the conflict in the Middle East.
We’ll be looking to see whether the current trade truce, which suspends higher reciprocal tariffs and is due to expire in November, will be extended, as well as any new announcement on easing trade tensions between the world’s two largest economies. We'll also be looking out for the outcome of discussions between the US and China on AI safety risks, amid recent calls from US tech majors to slow down the pace of global AI advancement.
And finally...
The UK’s parliamentary culture committee is investigating the country’s “dismal record of achievement” at the Eurovision song contest in recent years. The committee is expected to hear evidence from music industry experts, which may shed light on why the UK has finished in last place six times since the turn of the century – nul points of order