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Extreme uncertainty over the Iran war will put the Bank of England’s new approach to monetary policy to the test this week as investors seek clarity over the outlook for interest rates.

The shock to energy prices has dashed hopes that the bank’s Monetary Policy Committee would cut rates when it meets on Thursday, in a blow to chancellor Rachel Reeves’ claims that her Budget policies had paved the way for lower borrowing costs.

Instead, traders are betting the benchmark rate will stay at 3.75 per cent in the short term — and is more likely to rise than to fall by the end of 2026. 

But this is little more than a holding position: it splits the difference between radically different scenarios that could play out in the economy, depending on how long the conflict lasts and how severely it damages energy infrastructure and global supply chains. 

“It is simply too early to judge the scale and persistence of the likely inflation impact from the energy shock,” said Allan Monks, chief UK economist at JPMorgan. The MPC also faced a dilemma, he said, on whether to worry more about the hit to growth, or the risk of lasting price pressures “in the light of the bruising experience of the past few years”. 

Yet this is exactly the kind of situation the BoE should be equipped to navigate as a result of changes to its forecasting recommended by former Fed chair Ben Bernanke.

Under reforms led by deputy governor Clare Lombardelli, the BoE has de-emphasised its central forecast for inflation and growth, which it no longer presents as the collective view of the MPC. Instead it is making more use of “scenarios” to show how it might respond to unpredictable events.

Analysts have so far been dubious of the value of this new approach, criticising the MPC for selecting scenarios that differed only marginally from its central case and giving little steer on which scenarios individual members of the committee found more convincing.

But David Aikman, director of the National Institute for Economic and Social Research, said it was now the “ideal moment” for the MPC to put its new toolkit to use.

“In this environment, a single central forecast risks conveying a false sense of precision,” he said. Scenarios would be a much better way “both to underline the uncertainty it faces and to explain more transparently how different contingencies would shape its thinking”.

“The one thing you can do in a situation like this is to look at scenarios,” said Sandra Horsfield, economist at Investec, noting that the BoE could “dust off” and update analysis it published in August on the potential implications of higher energy prices.

But for this to be useful, the MPC would need to explain better “what each scenario would mean”, Horsfield added. 

While the MPC may be looking at scenarios internally, it is unlikely to set out any detailed analysis this week as it will not be updating its full forecasts until April.

The bigger issue is that individual members are likely to disagree on what any given trajectory for energy prices would mean for inflation in the medium term, once the initial shock has dissipated.

Even if oil and gas prices subside swiftly, inflation now looks likely to remain above the BoE’s 2 per cent target for most of this year. After five years that have led households to expect higher inflation, there is a clear risk this will reignite underlying price pressures.

“Central banks can’t ‘look through’ the inflationary effects of energy price shocks in the way they have before,” said Andrew Goodwin at the consultancy Oxford Economics.

“They are trying to set policy in a situation where no one knows what is going to happen and they have been continually above target forever — so the bias has to be slightly hawkish,” said Robert Wood, chief UK economist at the consultancy Pantheon Macroeconomics.

But the latest energy shock is unfolding against a very different economic backdrop from that of 2022, when Russia’s full-scale invasion of Ukraine sent gas prices to much higher levels.

Weak growth, rising unemployment and tightening fiscal policy could make it much harder for businesses to pass higher energy costs on to consumers — and easier for them to resist demands from workers for higher wages.

Dani Stoilova, economist at BNP Paribas, argued this weaker starting point meant there would be “a high bar for rate hikes, even if energy prices rise steeply”. Rate increases were only likely if inflation expectations drifted higher, the jobs market steadied or the government stepped in with “meaningful” fiscal support to cushion households from the shock.

The stagflationary effects of high energy prices are also likely to weaken GDP growth further by eroding households’ spending power and because the shift in market expectations for rates has already made mortgages more expensive.

The immediate task for the MPC, Wood argued, was to keep its options open. But in April, its members would need to be “braver” in using scenarios to explain what they saw as the least risky course of action.

“We have no idea how to attach probabilities to these scenarios because they depend on what Donald Trump does tomorrow,” Wood said. “So what is the most robust policy I can choose — if I cut and the shock is permanent or if I hike and the shock goes away?”

He added: “You’ve got to have the courage to say what it means.”