Amid ongoing geopolitical tensions in the Middle East, central banks have largely maintained steady interest rates, adhering to traditional economic guidance that energy shocks only contribute to sustained inflation if they alter wage and price-setting behaviors—known as second-round effects. Although it remains unclear whether such effects have materialized from the current energy disruption, historical patterns suggest the Bank of England may need to take preemptive action to mitigate persistent inflationary pressures in the UK.

Second-round effects arise when inflation expectations among households and businesses rise, prompting workers to seek higher wages to preserve purchasing power and companies to increase prices to safeguard profit margins. This dynamic can create a feedback loop, resulting in prolonged inflation.

An examination of past energy shocks provides context for understanding the current situation. During the 2011 energy shock triggered by political unrest in the Middle East and North Africa, second-round effects were limited; inflation peaked near 5 percent and the Bank of England kept rates unchanged. Conversely, following Russia’s 2022 invasion of Ukraine, more pronounced second-round effects drove inflation above 11 percent, prompting a series of interest rate hikes. The differing outcomes reflect both the nature of the shocks and the prevailing economic conditions at those times.

Although the full magnitude of the present shock remains uncertain, key indicators offer some insight. Real oil prices currently stand below prior peaks, while natural gas prices have surpassed 2011 highs but remain well below 2022 levels. Given gas prices heavily influence electricity costs in the UK, their trajectory plays a significant role in inflation. Meanwhile, household inflation expectations and company price forecasts have already risen significantly this year, particularly following the conflict involving Iran.

Labour market conditions further shape the inflation outlook. Compared to 2011 and 2022, the current labor market exhibits moderate tightness. Metrics such as the ratio of voluntary job changes to redundancies and vacancy-to-unemployment ratios suggest more slack than in 2022 but tighter conditions than in 2011. This environment indicates a relatively lower risk of wage-driven second-round effects currently, though companies facing squeezed profit margins may still pass higher costs onto consumers, as evidenced by recent spikes in input price readings from purchasing managers’ surveys.

A critical distinction of the present situation is that this shock marks the third negative supply shock in six years, with inflation remaining persistently above target throughout much of that period. This sustained inflationary environment means that prior restrictive monetary policies have yet to fully eliminate second-round effects from the last shock. Furthermore, households and firms appear increasingly sensitive to rising inflation; research suggests long-term inflation expectations are less firmly anchored and respond more strongly to short-term inflation surprises than in previous episodes.

While inflation rates are not escalating as rapidly as in 2022, this heightened sensitivity may still generate some second-round effects despite the softer labor market. Currently, tighter financial conditions help restrain inflationary pressures, but this influence may diminish unless interest rates are increased. As the conflict in the Middle East continues, the argument for raising rates grows stronger to prevent inflation from becoming further entrenched.