Bank of England Stuck in Stagflation Squeeze as UK Firms Lose Pricing Power Amid Oil Shock

The current conflict in the Middle East has triggered a supply shock of historic proportions. According to the International Energy Agency, the war is creating the largest supply disruption in the history of the global oil market. The choke point is the Strait of Hormuz, where crude and oil product flows have collapsed from around 20 million barrels per day before the war to a near standstill. To compensate, Gulf countries have cut total oil production by at least 10 million barrels per day. This unprecedented curtailment has sent prices soaring, with Brent crude jumping to more than $107.6 a barrel following recent escalations.

The shock is now fully transmitted to UK consumers. In March, the average price of a litre of unleaded petrol rose by 20p, marking the sharpest monthly increase since the Ukraine war. Diesel prices jumped even more sharply, up 40p. These are record rises that far exceed previous benchmarks, underscoring the direct and severe impact on household budgets.

This price surge is forcing a reassessment of the Bank of England's stance. Internal BoE models suggest the shock will have a significant inflationary impact, potentially running approximately 40 basis points higher in 2026 than previously forecast. Analysts note this could prompt a more hawkish tone than expected, with the central bank likely to hold rates unchanged to buy time and guard against a resurgence in inflation expectations. The immediate pressure is clear: energy prices are now a dominant force in the UK's economic equation.

The Stagflationary Trade-Off: Business Pricing Power vs. Weak Demand

The energy shock has created a classic stagflationary trade-off for UK businesses. On one side, firms are under intense pressure to pass on soaring costs. On the other, weak demand and a lack of pricing power are making that difficult. The Bank of England's latest survey captures this tension. UK businesses polled in March said they plan to raise prices by 3.7% over the next year, the highest level since October and up from 3.4% the month before. This indicates a clear build-up of inflationary pressure as firms seek to protect margins.

Yet the data also shows a critical constraint: the ability to actually do so is fading. The same survey reveals that wage expectations eased by 0.1 points to 3.4%, the lowest since the Bank started collecting the data in 2022. At the same time, employment plans deteriorated further. This combination signals that firms lack the market power to fully shield themselves. With workers less willing to demand higher pay and companies scaling back hiring, businesses face a weak demand environment that limits their ability to raise prices without losing customers.

The result is a squeeze on corporate profits. As Governor Andrew Bailey noted, companies have only limited power to pass on higher costs. The energy shock pushes up prices, but the weak underlying economy prevents firms from passing them on in full. This dynamic creates a difficult balancing act for monetary policy. The Bank of England is caught between the risk of second-round inflation effects from higher energy costs and the threat to growth and jobs from weak demand. For now, the central bank is likely to hold rates steady, but the stagflationary cross-currents are becoming impossible to ignore.

Policy Response and Market Expectations: The Hawkish Turn

The Bank of England is expected to hold its key rate steady at 3.75% this week, buying time to assess the full impact of the energy shock. While a hike remains unlikely given weak demand and a rising unemployment rate, the central bank is poised to signal a significant shift in its outlook. Internal models suggest the war's inflationary impact is about three times larger than our estimate, prompting analysts to expect the MPC to adopt a more hawkish tone than we expect. The committee will likely state that the recent surge in energy prices has shifted the balance of risks to the upside for near-term inflation.

This hawkish pivot is already reshaping market expectations. Bank of America now forecasts two rate cuts, but they are delayed until June and September. This revision marks a clear retreat from earlier expectations of cuts in March and June. The move reflects a growing consensus that the energy shock introduces stagflationary risks that could delay the return to the 2% target. As one analysis notes, the bar for a rate hike remains high, but the path for easing is now much less certain.

The most sensitive development is in inflation expectations themselves. Britons' short-term inflation expectations climbed to 5.4% in March from 3.3% in February, a surge that occurred at a "sensitive moment" for the MPC. This jump is critical because household expectations can trigger a wage-price spiral, prolonging actual inflation. The Bank of England is acutely aware of this feedback loop, with research showing expectations tend to respond strongly to energy supply shocks.

The bottom line is a policy crossroads. The BoE is caught between a rock and a hard place: holding rates steady to guard against second-round effects while a weak economy limits its ability to raise them. Markets have fully unwound previous expectations of easing, now pricing in a high probability of a hike by year-end. For now, the central bank will likely maintain its hawkish stance, but the energy shock has fundamentally altered the trajectory, making the path for rate cuts both delayed and more uncertain.

Catalysts and Risks: The Path to Resolution

The trajectory from a temporary energy shock to a sustained stagflationary period hinges on a few key variables. The primary catalyst is the duration of the Middle East conflict and, crucially, the resumption of shipping through the Strait of Hormuz. The International Energy Agency notes that crude and oil product flows through the Strait of Hormuz have plunged from around 20 mb/d before the war to a trickle currently. Until these flows normalize, supply losses are set to persist, keeping prices elevated and inflationary pressure high. The BoE's own analysis suggests the shock's impact is about three times larger than our estimate, with inflation potentially running 40 basis points higher in 2026 if the conflict extends into the second quarter.

A major risk is that this shock triggers a wage-price spiral. The recent surge in short-term inflation expectations to 5.4% in March from 3.3% in February is a critical warning sign. If households demand higher pay to offset soaring costs, and firms pass those demands on through prices, the BoE's ability to cut rates will be severely constrained. While wage growth has moderated to 3.4% for 2026 pay settlements, the central bank remains sensitive to second-round effects. A persistent energy shock could easily reverse this progress, forcing the Bank to delay cuts further to guard against a self-reinforcing cycle.

Political pressures are also mounting. The upcoming UK local elections on May 7 could increase demands for fiscal support to ease the burden on households. Such measures, while politically expedient, would complicate the BoE's mandate by adding direct fiscal stimulus to an already inflationary environment. This creates a difficult policy cross-current, where monetary tightening is needed to control inflation, but political pressure may push for countervailing fiscal easing.

The bottom line is one of high uncertainty. The path forward depends on a swift resolution to the conflict, the resilience of inflation expectations, and the political will to let monetary policy do its job. For now, the BoE is navigating a narrow path, with the energy shock having fundamentally altered the economic landscape and made the return to its 2% target both more difficult and more distant.