Amid the ongoing conflict in the Middle East, major central banks have largely held interest rates steady, following traditional economic guidance that energy shocks only translate into sustained inflation if they lead to changes in wage and price-setting behaviors, known as second-round effects. While it remains too early to determine whether such effects are taking hold from the current energy shock, analysis of past episodes suggests that central banks, particularly the Bank of England, may need to consider proactive rate increases to mitigate inflationary pressures.

Second-round effects occur when households and companies adjust their inflation expectations upward, prompting workers to seek higher wages to protect their living standards and companies to raise prices to maintain profit margins. This dynamic can create a feedback loop between wage demands and price increases, potentially leading to persistently elevated inflation.

Historical comparisons highlight differing outcomes from previous energy shocks. The 2011 shock, triggered by unrest in the Middle East and North Africa, resulted in moderate inflation increases with relatively stable inflation expectations and limited changes in wage-setting. By contrast, the 2022 shock following Russia’s invasion of Ukraine brought about a sharp surge in inflation, exceeding 11 percent, accompanied by significant increases in both household and company inflation expectations, as well as tighter labor markets. Interest rates were raised in response.

The current energy shock, driven in part by the recent conflict in Iran, has caused household inflation expectations in the UK to rise noticeably, with company price expectations also increasing sharply. However, the labor market indicators suggest it is somewhat looser now than in 2022 but tighter than in 2011. Measures such as the ratio of voluntary job changes to redundancies and the vacancy-to-unemployment ratio indicate moderate worker bargaining power at present, higher than in 2011 but lower than during 2022. This suggests a greater risk of companies passing through cost increases via price-setting rather than wage hikes.

Additionally, companies, having experienced profit margin pressures in recent years, may be more inclined to elevate prices if energy costs rise and competitors face similar challenges. This is reflected in the recent increase in output prices reported by purchasing managers.

Analysts note that the current shock is the third major negative supply shock in six years, occurring in an environment where inflation has remained above target for much of that time. This raises concerns that second-round effects from previous shocks have not been fully addressed by monetary policy and that inflation expectations have become more sensitive to short-term fluctuations since 2022. With inflation expected to reach thresholds between 3 and 3.5 percent, there is heightened risk of inflation feeding into longer-term expectations, weakening their anchoring.

While inflation today is not rising as rapidly as in 2022, this increased sensitivity could still prompt second-round effects, even amid some labor market slack. Presently, tighter financial conditions help counteract these pressures, but without further interest rate increases, that mitigating influence may erode. Consequently, the persistence of the conflict and ongoing energy market volatility strengthen the case for central banks, including the Bank of England, to consider raising rates to prevent entrenched inflation.