UK Stagflation 2026: Why the Bank of England May Hike Rates, Not Cut Them

The United Kingdom is heading into a second consecutive year of what economists at RSM UK are calling “stagflation-lite,” a combination of sluggish growth and rising inflation driven by an energy shock that traces directly back to the closure of the Strait of Hormuz. Bank of England Governor Andrew Bailey has said market pricing for two rate cuts this year looked reasonable before the Iran war lifted inflation risks, a shift in tone that now has traders debating whether the next move is a cut, a hold, or an outright hike, according to the Credit Protection Association’s business briefing.

Growth That Keeps Disappointing

The headline numbers tell a story of an economy losing momentum even before the latest shock fully lands. UK GDP grew just 0.1% at the end of 2025, revised down from an initial 0.2% estimate, and while first-quarter 2026 growth came in stronger at 0.6%, GDP then fell 0.1% in April, according to the Office for National Statistics data cited by CPA. Real household disposable income fell 0.8% in the first quarter as rising prices and higher taxes squeezed consumers, and business confidence data from the Institute of Directors showed its sentiment index falling to minus 61 in June from minus 53 in May, the lowest revenue expectations reading of the year.

RSM UK’s economic outlook frames the underlying trajectory starkly: GDP growth of just 1.0% this year, down from 1.4% in 2025, with inflation trending back toward 4%, “another dose of ‘stagflation-lite,'” the firm wrote in its assessment, per RSM UK. The firm’s base case sees inflation averaging 3.1% in 2026 and peaking around 3.5%, though it warns the risks are larger than usual given how heavily the outlook depends on developments in the Middle East.

The Energy Shock’s Direct Line to Household Bills

The mechanics of the inflation threat are unusually direct this time. A 13% rise in the energy price cap in July, combined with higher motor fuel costs and pass-through effects into food and supply chains, is expected to push inflation back toward 3.5% by year end, RSM UK’s analysis found. Oil prices, which had briefly dipped, rose to an average of over $100 a barrel within 30 days of the Iran conflict’s outbreak, though RSM UK notes the closure of the Strait of Hormuz represents the largest oil supply shock in history, and energy markets have so far reacted with relative calm, with oil now around $79 a barrel, well below the post-Ukraine invasion peaks.

That calm may not last. High global oil stocks have provided a buffer, but these are being run down at a record rate and could reach critical levels by September if the June peace deal between the US and Iran proves fragile, according to RSM UK’s forecast. KPMG UK’s separate economic outlook adds that the disruption to oil and gas supplies has already put upward pressure on energy prices, with headline inflation expected to rise from the third quarter onward as the spike gradually feeds through, per KPMG UK.

A Central Bank Caught Between Two Mandates

The Bank of England’s Monetary Policy Committee held its base rate at 3.75% through the first half of 2026, pausing a cutting cycle that had brought borrowing costs down from a 16-year high, according to NewsNow’s aggregated coverage of the situation. The next MPC decision falls on July 30, and while a base rate rise isn’t off the table, most analysts expect the committee to use the meeting to assess how durable the US-Iran peace deal proves before committing to any directional shift, according to mortgage-market analysis from Tembo Money.

The labor market complicates the calculus further. Unemployment has risen to around 5.1% to 5.2% as slower growth and higher employer National Insurance contributions weigh on hiring, even as pay growth cools from recent highs, easing the case for further rate cuts while simultaneously pressuring real household incomes, per NewsNow’s summary. KPMG UK’s modeling suggests that if the Middle East disruption proves short-lived and both oil and gas prices decline before summer’s end, inflation could still fall from a September peak toward the Bank’s 2% target by the second quarter of 2027, but that scenario now looks less certain than it did in the spring.

Politics Compounds the Uncertainty

Economic uncertainty is being amplified by domestic political developments. RSM UK’s outlook specifically flags the prospect of a change in Prime Minister as adding headwinds through higher borrowing costs and gilt yield pressure, noting that gilt yields are likely to remain elevated regardless of what the Bank of England does with the policy rate, given the UK’s particular sensitivity to inflation surprises and its unresolved political landscape. Hospitality businesses have separately renewed calls for a VAT cut, with almost a quarter of venues reportedly operating at a loss even before the latest energy price increases take effect, according to CPA’s reporting.

RSM UK’s own assessment of the year ahead captures the mood succinctly: the economy has grown at an average of just 1.2% through two turbulent years, and while early signs suggest that resilience will hold, the firm’s base case remains slower growth paired with rising inflation, not recession, but with a bigger-than-usual health warning attached to that call.