Bank of England should raise interest rates to 5%, Niesr says

The National Institute of Economic and Social Research has called for UK interest rates to reach 5%, arguing that the Bank of England’s response to rising inflation has been insufficient. Its assessment follows the Bank’s increase from 3.75% to 4% last week, the first rise since August 2023, as policymakers confront higher energy costs linked to the Iran war.

The institute’s November forecasts put the peak in Consumer Prices Index inflation at about 4.4% in February 2027. That compares with the 3.8% peak it forecast in July and the latest reported inflation rate of 3.5% in September. The Bank’s target is 2%, leaving a substantial gap even before the further increase Niesr expects.

Niesr distinguishes between what it expects policymakers to do and what it believes they should do. Its forecast assumes one more rate increase, but the institute considers that insufficient and projects a return to target only in late 2030. The proposed 5% rate is its policy recommendation, not an announced Bank decision or its prediction of the Bank’s next move.

The warning also covers government finances. Niesr argues that Chancellor John Healey postponed important tax and spending choices in October’s Budget, leaving plans exposed to a potential £30bn shortfall. That figure is conditional: it reflects what could happen if planned spending restraint slips by amounts comparable with previous plans, rather than an established current deficit against the fiscal rules.

The growth outlook is mixed. Niesr raised its forecast for 2026 to 1.6% from 1.4%, citing government spending and business investment, including investment in artificial intelligence. But it cut its 2027 forecast to 1.1% from 1.3%, suggesting that the stronger performance this year is not expected to carry through into the next.

The immediate inflation pressure comes from energy. Oil and gas prices have risen sharply since the United States and Israel began their war against Iran at the end of February. Brent crude has frequently traded above $100 a barrel in recent weeks, compared with about $70 before the conflict, increasing costs faced by households and businesses.

Oil prices nevertheless fell on Tuesday, with Brent briefly dropping below $90 a barrel to its lowest level since 31 August. The move followed Donald Trump’s comments playing down the need for military action against Iran at that point. Niesr’s UK and global growth forecasts use an oil-price assumption of $105 a barrel, making the durability of that fall important.

A lower crude price would not necessarily translate quickly into lower consumer prices. The institute cited continuing disruption to shipping and refining as reasons for a slower adjustment. Stephen Millard, its deputy director, also questioned whether the change in US policy would last, pointing to Trump’s previous changes of position rather than treating Tuesday’s market move as a settled trend.

Niesr’s concern extends beyond the initial energy shock to decisions on wages and prices. Its projected inflation peak coincides with the period when many employers agree pay awards for 2027. The labour market has also held up better than expected during the war, with unemployment falling to 4.7%, which the institute sees as increasing the likelihood of pay rises.

The public finances have become less forgiving. Healey’s Budget put fiscal headroom at £14.5bn, down from £23.6bn, linked to higher debt-interest costs over the preceding year. Separately, official figures published in October showed national debt reaching £3tn for the first time in September. Those developments provide the backdrop to Niesr’s demand for more credible funding plans.

David Aikman, Niesr’s director, argues that waiting could require a larger monetary response later. With inflation expected to exceed 4% around the time of annual pay agreements, he said: “One further quarter-point rise is unlikely to be enough”. His case is that the Bank must address the risk of continuing domestic price pressure, not simply the original rise in fuel costs.

James Smith, a chief economist at Niesr, described the Bank as “behind the curve”, according to the Telegraph report included in the supplied coverage. He identified possible increases in wages and profits as routes through which the shock could persist. These are warnings about how businesses and workers may respond; the reporting does not establish that those outcomes are inevitable.

The Bank’s public position leaves further tightening open. Governor Andrew Bailey has warned that additional increases may be necessary. Deputy governor Clare Lombardelli said on Tuesday that she would not rule out either December or February, and that another near-term increase would probably be justified unless evidence showed inflationary pressure weakening. Her remarks were conditional, rather than a commitment to a particular meeting.

Lombardelli also set out the risks facing employment. Companies have so far absorbed some higher energy costs through reduced margins, she said, but cannot do so indefinitely. A prolonged shock could lead them to raise prices, restrain wages or reduce employment, including changes to existing staffing rather than hiring plans alone. Her comments underline the uncertainty over how firms will adjust.

On fiscal policy, Smith criticised both the Labour government and its Conservative predecessors for failing to confront the available choices. Niesr says commitments covering defence, social care and disability remain unfunded. It had already called in the summer for tax increases or reform, or spending reductions, to finance new defence and cost-of-living commitments, rather than prescribing only one route.

The next monetary-policy decisions will depend on incoming evidence, with Lombardelli explicitly leaving successive increases possible. The supplied reporting also says the Bank has warned inflation could reach 6% next year. That warning should not be confused with Niesr’s central forecast of a 4.4% peak: the coverage does not provide enough detail to reconcile the assumptions behind the two figures.

The household consequences are uneven. Niesr says persistent inflation would fall hardest on poorer households because they have less scope to use savings or alter their spending. Its argument for stronger action therefore includes the cost of allowing inflation to continue, rather than considering only the consequences of increasing interest rates.

The Treasury faces a funding test alongside the Bank’s inflation challenge. Aikman warned that investors could demand higher returns on lending to the government if spending in areas such as defence rises without offsetting savings. Niesr says the existing fiscal plans depend heavily on spending restraint in later years; the reports supplied do not include a Treasury response to its criticism.

Beyond next year, Niesr forecasts growth slowing to 0.9% in 2028 as inflation, borrowing costs and restricted government spending weigh on consumer and business confidence. Millard warned that another economic shock could push debt higher again. The institute’s outlook consequently depends on both the persistence of international pressures and domestic decisions that have yet to be made.