The Bank of England is expected to keep interest rates unchanged as the energy shock subsides, weakening the urgency to raise rates.

As inflation threats are not as severe as expected and energy costs are expected to decrease due to hopes of the Middle East conflict ending, the Bank of England is expected to keep interest rates unchanged on Thursday. Currently, both traders and economists believe that the Bank of England will keep interest rates at 3.75% on Thursday. The Middle East conflict has already impacted the real economy. However, this week, with the new ceasefire agreement in the Middle East and a significant drop in oil prices, the likelihood of inflation peaking far below the Bank of England's most optimistic scenario is higher. Traders are still factoring in expectations of a 25 basis point rate hike this year, but many economists believe that the interest rates have peaked. A survey conducted from June 10th to 12th showed that economists expect the Monetary Policy Committee (MPC) of the Bank of England to vote 7-2 in favor of keeping interest rates unchanged. Chief economist Hugh Pill and external member Megan Green are expected to support a rate hike to prevent recent energy-driven inflation from becoming a long-term issue. Pill previously voted in April to raise rates to 4%, while Green has always been concerned about the "second round effect" of inflation on wages and prices, stating that "as the conflict continues, the case for a rate hike is strengthening." Regardless of how these two vote this time, they may emphasize the results of the Bank of England's own survey - that British households expect prices to rise 4% over the next 12 months, double the Bank of England's 2% target. However, dovish officials are still expected to dominate, as concerns about weak labor market demand persist. It was these factors that drove the Monetary Policy Committee to lean towards cutting interest rates before the war broke out. Deputy Governor for Monetary Policy Claire Lombardelli and committee member Catherine Mann are seen as potential hawks, but are not expected to join the camp of those pushing for a rate hike this month. Although UK bond yields have fallen somewhat, they are still higher than pre-war levels. Bank of England Governor Andrew Bailey has described the current policy stance as "actively unchanged". This means that the tightening financial environment is taking the place of the Bank in restraining demand. With the Bank of England ruling out the possibility of interest rate cuts, while the market still expects the possibility of rate hikes in the future, the Monetary Policy Committee has effectively achieved the equivalent of three 25 basis point rate hikes since early February, without actually raising the policy rate. Families and businesses are feeling the pressure through higher mortgage and credit costs. However, in the past week, the market environment has significantly eased, which may actually raise new inflation concerns. Swap rates used to set mortgage rates have fallen, while the 10-year UK government bond yield has dropped to a two-month low of 4.75%. Peak inflation in the UK may be lower than the Bank of England's most optimistic forecast In April this year, the Monetary Policy Committee of the Bank of England stated that they would "continue to closely monitor the situation in the Middle East and how its effects are transmitted to the economy." The committee also stated: "The committee is prepared to take action when necessary to ensure that the CPI inflation rate returns to the 2% target level in the medium term." Economists believe that given the high degree of uncertainty surrounding the situation in the Middle East and the economic outlook, this wording is likely to be retained. The Bank of England may lean towards a more moderate inflation scenario Policy makers may use scenario analysis to demonstrate a change in their thinking. In April this year, the Bank of England presented three scenarios, all of which maintained inflation rates above 3%. At that time, the majority of committee members favored the middle scenario - scenario B - which implied the need for higher interest rates. Now, as oil prices have significantly fallen below the predicted levels in all of the Bank of England's models, policy makers may gradually shift towards scenario A - a short and mild energy shock that will not lead to a second round of inflationary effects, and does not require a rate hike. Deputy Governor Dave Ramsden has stated that if "some of the downside risks in scenario A truly materialize, I would tend to support a more accommodative policy path." With the improvement in the outlook for the Middle East geopolitical situation leading to a significant drop in energy prices, the peak inflation in the UK is expected to be much lower than the levels predicted in the Bank of England's most optimistic scenarios. Based on current energy prices, UK inflation is expected to only rise to around 3%. This level is significantly lower than the peak of 3.6% predicted later this year in the Bank of England's most optimistic scenario, and much lower than the inflation peak of over 6% in early 2027 in the most pessimistic scenario. Economists Dan Hansen and Anna Andrada stated: "If calculated based on the daily market valuation using the June 16th oil and natural gas futures curve, the inflation rate for the next year will remain close to 3%." They noted that if the current trends in the energy market continue, it will provide room for the Bank of England to keep interest rates unchanged in the coming months rather than hiking, which is also their current baseline prediction. Data released on Wednesday showed that UK inflation in May was 2.8%, lower than market expectations, further increasing pressure on hawkish members of the Monetary Policy Committee to reassess their stance. Although the UK's maximum energy price cap for July has been determined to increase by 13%, which will push inflation higher, the drop in oil prices may offset some of the effects of a future decline in gasoline prices in the coming months. While traders are currently factoring in a rate hike expectation, the pressure for the Bank of England to ease policy again may rise as the inflation outlook improves and market focus shifts to the weak labor market. Tomas Villadec, Chief European Macro Economist at T. Rowe Price, stated: "Given the impact on the real economy, the next step is likely to be a rate cut."