The outlook for inflation − speech by Clare Lombardelli

Speech

It is an honour and a pleasure to be invited to speak to you today at the Sixth Biennial Conference on Macroeconomic Policy.

Policymakers often say we are dealing with an unusually uncertain time. And I will not disappoint you. The economy faces large and complex uncertainties: geopolitical tensions, global structural shifts and the rapid march of technology. The world is changing, and those changes are interacting, with significant implications for inflation.

Today I will discuss the global energy shock and its implications for inflation and monetary policy. I will first review the framework that the Monetary Policy Committee (MPC) is using to assess how the global energy shock is affecting UK inflation.^{footnote [1]} I will then assess the near- and medium-term outlook before discussing what it means for policy, both through the lens of the Committee’s recent decisions and my own perspective. I have three main messages.

First, the main driver of near-term inflation is developments in global energy prices. The energy shock due to the conflict in the Middle East has already pushed up UK inflation, and we expect it to continue to do so in the coming months. There is significant uncertainty about how the conflict will develop, and so about the evolution of energy prices.

Second, the medium-term outlook depends on how the energy shock propagates through the economy through indirect, demand and second-round effects. The key judgement for monetary policy is whether emerging evidence suggests inflation may become persistent. This risk is cumulative. The longer energy prices remain high and volatile, the greater the risk for pass-through more widely into domestic wages and prices.

Third, given the uncertainty, policy decisions are necessarily made with incomplete information. As evidence emerges we will learn about the shock, its transmission, and the risks around these. We cannot offer firm guidance on the path of policy, but we can be transparent about the reaction function: this depends on how the shock evolves, how it propagates through the UK economy and what that implies for medium-term inflation.

The effects of a global energy price shock on UK inflation

A global energy price shock affects UK inflation through four channels: direct effects on household energy costs; indirect effects through firms’ production costs and supply chains; demand effects through real incomes and spending; and second-round effects through expectations, wages and domestically set prices. Table A summarises the mechanism, timing and potential policy response for each channel.

Table A: Global energy shocks can affect UK inflation through several channels

Energy is an important part of households’ consumption, and pass-through from global oil and gas prices to the petrol and utility prices that households pay is relatively fast.^{footnote [2]} Large changes in energy prices can have quick and significant direct effects on aggregate inflation. Monetary policy cannot prevent the initial rise in inflation caused by higher energy prices. Rather, its role is to ensure that temporary increases in inflation do not become persistent inflationary pressure, as I will return to in more detail later.

Energy price increases also have indirect effects on inflation, as energy is an important input to the production of many goods and services, for example, the production and delivery of food. Firms may try to pass on the increases in energy costs they pay to consumer prices. Indirect effects tend to feed through more slowly than direct effects. And they can increase disproportionately with the size and persistence of an energy shock as firms become less able to absorb cost increases in their margins.

The most pernicious effects are second-round effects. These arise if the increase in energy prices generates inflationary pressures across domestically set wages and prices beyond the direct and indirect costs of higher energy. Second-round effects are likely to be stronger the larger and more long-lasting the energy price shock is. For example, higher inflation arising from larger direct and indirect effects could feed through via higher inflation expectations into the prices companies set. Higher inflation could also make it more likely that wages rise to maintain purchasing power – which in turn would push up firms’ costs and could lead them to raise prices by more.

Finally, the decline in real incomes due to higher energy prices could lead households to reduce consumption or firms to reduce investment, reducing economic activity.^{footnote [3]} Such demand effects are likely to be stronger the more persistent households and firms expect the energy shock to be, and the more financially constrained they are. Weaker demand can reduce the inflationary impulse of an energy price increase. It also worsens the policy trade-off, as monetary policy cannot at the same time lean against upside risks to inflation and protect against downside risks to demand and the labour market.

The near-term outlook for inflation

So, what have we seen? The direct effects from higher energy prices have raised inflation broadly as expected, while indirect pass-through has so far been weaker and firms’ and households’ demand more resilient than anticipated. I will examine each part of that evidence, before turning to the medium-term risks.

The conflict in the Middle East has caused the near-term outlook for inflation to be unusually volatile. In the pre-conflict February 2026 Monetary Policy Report, we expected CPI inflation to fall back to the 2% target by the summer. As Chart 1 shows, the projections rose materially with the onset of the conflict and have been volatile since. Without clear resolution in the Middle East, volatility in estimates for near-term inflation will likely continue.

Brent crude oil prices have fluctuated between lows of around $70 to well over $110 per barrel since the start of the conflict. In the weeks since our most recent July Report, they have increased by 26% to around $98 as of Tuesday. Natural gas prices have similarly been volatile and have increased by around 50% in recent weeks. In addition, pressures on refineries in several countries mean that crack spreads – the difference between the prices of refined petroleum products and Brent crude oil – have risen well above their pre-conflict levels. This has amplified the increases of petrol, diesel and jet fuel prices.

Chart 1: The near-term outlook for CPI inflation has shifted materially in recent months

CPI inflation and near-term projections ^(a)

Footnotes

• Sources: ONS and Bank calculations.
• (a) The solid grey line shows CPI data to August 2026. The dashed purple, orange, and aqua lines show near-term projections at the time of the February, April and July 2026 Reports, respectively. The dashed gold line shows a mechanical update of near-term projections following the release of the August CPI data on 16 September.

Higher global energy prices have pushed up motor fuel prices for UK consumers. For example, petrol prices have increased from around 132 pence per litre to around 172 pence per litre between February and September. And the Ofgem energy price cap will increase by almost 4% in October, taking an average annual household utility bill to £1,723. That is currently projected to rise further to over £2,000 in the first quarter of next year. The Bank’s latest near-term inflation forecast now points to CPI inflation rising from its current level of 3.1% to around 3.7% in 2026 Q4 and to around 4.2% in 2027 Q1, materially higher than our projection in July. Measures announced in last year’s Budget and the temporary cut to VAT on electricity until March 2027 are mitigating the direct effects of higher energy prices on inflation. Without these measures, the inflation projection for the first quarter of next year would likely be closer to 4.5%.

While direct effects have evolved broadly as expected, indirect effects have been smaller. In April we projected indirect effects would add about 0.3 percentage points to CPI inflation in August.^{footnote [4]} But so far there is little evidence that firms are passing higher energy costs through to the prices of other goods and services. Inflation for energy-intensive parts of consumption such as food have come in below projections. A key question is whether these indirect effects will ultimately prove to be lower or slower.

So far, businesses have proved more resilient to higher energy costs than we expected. Firms may have had greater hedges than we thought. They may be temporarily absorbing higher energy costs in their margins given subdued demand conditions and limited pricing power. But there will be a limit to businesses’ ability to absorb higher costs, and any hedges that may be in place will eventually run out. If energy prices revert to a lower level soon, we may never see these indirect effects.

But the larger the energy shock becomes and the longer it persists, the more likely it is that we will eventually see significant pass-through of higher energy costs to other prices. And the level and persistence of energy prices are not the only things that matter. Greater volatility can affect pricing dynamics by increasing attention to inflation and making expectations more responsive to shocks (Mann (2025a)). If wages and prices are sticky downwards, volatility can bring an upward inflation bias. And greater uncertainty about the outlook can also encourage households to build precautionary savings buffers, affecting demand as well as inflation dynamics (Mann (2025b), Fischer et al (2025)).

Energy prices are not the only risk or uncertainty we face. Other global costs could add to inflation. Strong demand for AI components is already pushing up global export prices and weather-related shocks add upside risks. On the other hand, trade diversion is reducing inflation. Recent empirical work by Bank staff suggests that trade diversion in response to tariffs has lowered UK CPI inflation by 0.1–0.2 percentage points in 2026.

Food price inflation has surprised to the downside in recent months, but is expected to rise from here. At 1.3%, it is at a 2-year low. This reflects a reversal in sharp rises for some specific items (such as beef and cocoa), receding pressures from labour costs and packaging regulations and the slower-than-expected pass-through of higher energy costs. Despite this welcome respite, the outlook for food prices is far from benign. Bank staff expect external pressures including high energy prices to push food price inflation up over coming quarters, to a little under 3% by the end of the year and towards 4% in 2027 Q1. Recent droughts across parts of Europe are likely to increase food prices, and extreme weather events such as a particularly strong El Niño pose material upside risks. Continued conflicts in the Middle East and Ukraine could disrupt agricultural exports and raise fertiliser prices. Some industry associations such as the Food and Drink Federation already forecast food price inflation to peak at over 6% in the summer of 2027.

Food prices are particularly important. Food accounts for about 11% of the overall consumption basket in the UK, so changes in food price inflation have a direct and sometimes material impact on CPI inflation. They account for a higher proportion of spending for those on low incomes. In addition, because many food items are essential goods that households regularly purchase, people tend to be particularly attentive to changes in food price inflation. Food prices have an outsized effect on households’ inflation perceptions and expectations (e.g. D’Acunto et al (2021), Bonciani et al (2024) and Anesti et al (2025)). This means that high food price inflation could contribute to second-round effects in domestic wage and price setting.

Higher energy prices do not yet appear to be weighing significantly on demand. GDP growth has been stronger than expected, and within that private consumption has held up well. While consumer confidence dipped immediately after the conflict, it has since recovered. Households appear to be smoothing through the real income shock, so we see a falling household saving ratio, though households’ ability to do this will be limited. Demand may weaken if energy prices remain high or rise further. But to date, both households and firms have proven more resilient to higher energy prices than expected.

Looking beneath the fast-paced changes driven by global energy prices, the underlying disinflation process has continued over the course of the year. Wages are a key driver of moves in underlying inflation because they are the largest cost component for many domestic firms, in particular in the services sector.

Chart 2: Private sector wage growth has continued to slow

Measures of private sector wage growth ^(a)

Footnotes

• Sources: DMP survey, HMRC, Indeed, ONS and Bank calculations.
• (a) See the footnote to Chart 1.4 in the July 2026 Monetary Policy Report for further details on these data.

The Bank monitors a broad set of indicators for wage growth (Chart 2). The Bank’s Agents report average pay settlements of 3.6% for 2026, below the average settlement of 4% in 2025. Contacts cite a lower National Living Wage (NLW) increase this year, lower inflation at the time of settling and a looser labour market as driving that fall. Overall, we have seen downward momentum across different indicators of pay growth this year, consistent with a relatively weaker labour market continuing to weigh on wages.

The rate of wage growth consistent with the inflation target depends on productivity growth and import price inflation (Lombardelli (2025)). Wage growth around 3¼% could be consistent with the inflation target in the long run, assuming productivity growth of around 1% and import price inflation in line with historical averages.^{footnote [5]} But for as long as higher energy prices continue to generate import price inflation, the rate of wage growth consistent with returning inflation to the 2% target will be lower.

The medium-term outlook for inflation

The near-term evidence leaves two medium-term questions unresolved: where energy prices go from here, and how strongly the shock will propagate through the UK economy—especially through second-round effects. The first determines the size and duration of the initial inflation impulse; the second determines whether it becomes persistent. Scenarios help us assess those risks without suggesting that either can be forecast precisely.

Recent reforms to our monetary policy processes in response to the Bernanke Review (Bernanke (2024)) have put risks and uncertainties more explicitly at the heart of our policy framework. This helps us make and communicate monetary policy decisions in the face of uncertainty. We use alternative scenarios to explore how the economy may evolve in ways that are key to the decisions we are taking. These scenarios capture plausible alternative outcomes rather than tail risks. And they provide a common framework for internal and external discussions about monetary policy.^{footnote [6]} Using the scenarios as a starting point, MPC members can express their personal views in a consistent and comparable way (Pill (2026)).

In July we published two scenarios alongside the central projection. In the central projection, energy prices followed their futures curves, second-round effects were assumed to be moderate, and were calibrated using the Bernanke-Blanchard model.^{footnote [7]} In a milder scenario, energy prices follow a slightly lower path, demand weakens and there are no second-round effects. In an adverse scenario, energy prices follow a persistently higher path consistent with repeated re-escalations of the conflict, and with additional second-round effects. These additional second-round effects stem from the scaling of the Bernanke-Blanchard model to higher energy prices and an additional mechanism in which inflation expectations drift higher, generating stronger and faster second-round effects through greater amplification in wage and price-setting.

Across the scenarios we consider the two key forms of uncertainty policy makers are facing: the size of the energy shock and the strength of propagation through second-round effects, as summarised in Table B. Our scenarios are based on the diagonals, because of the expected positive relationship between energy prices and second-round effects, but off-diagonal combinations are also possible.

These scenarios lead to different medium-term outlooks for inflation. In the near-term, differences largely reflect different energy price assumptions (Chart 3, left panel). But in the medium term, differences in second-round effects are important (Chart 3, middle panel). Conditioned on market interest rates at the time, inflation fell slightly below the 2% target in the medium term in the central projection and in the milder scenario but remained above 2% in the adverse scenario (Chart 3, right panel).

The geopolitical situation in the Middle East remains unresolved. And energy spot and futures prices have increased again. To date energy prices have evolved more in line with our adverse scenario. In contrast, news on how energy prices are feeding through the economy via indirect, demand, and second-round effects have been more mixed. As noted, indirect effects have so far been smaller than expected. But the longer energy prices stay high, the more likely indirect effects are to eventually come through. We have similarly seen little evidence of demand effects to date. But demand could still weaken if the energy shock persists or worsens further.

Chart 3: Relative to the central projection, inflation is higher in the adverse scenario and lower in the milder scenario, in part due to second-round effects

Brent crude oil prices, the additional impact on inflation from potential second-round effects, and annual CPI inflation in the central projection and scenarios ^(a)

Footnotes

• Sources: Bloomberg Finance L.P., LSEG Workspace, ONS and Bank calculations.
• (a) The scenarios shown here are conditioned on the same market curve for Bank Rate. Further details on conditioning assumptions can be found in Table 3.A of the July 2026 Monetary Policy Report and the Projections Databank accompanying that Report. The final projections are for 2029 Q3.

The likely scale of second-round effects remains a key as well a difficult judgement to make. Second-round effects can’t be observed directly and would occur with a lag. Our July scenarios suggested that in our adverse scenario second-round effects would start to emerge by Q4 this year, including indications from our 2027 pay survey. In the meantime, we continue to monitor a wide range of indicators (Boxes A and B in the July 2026 Monetary Policy Report). The data flow since the end of July has not materially changed the picture. Year-ahead wage growth expectations in our Decision Maker Panel survey have remained close to 3.5% through 2026 and continue to point to wage growth slowing by around 0.5pp compared with recent outturns. And the Bank’s Agents report that estimated average pay settlements for 2026 ticked up only very slightly to 3.6%. Firms expect to make very few one-off cost-of-living payments. Most contacts do not yet want to give a figure for expected 2027 pay deals, but some suggest it would be similar or slightly lower than in 2026. Meanwhile, firms’ own-price expectations in the DMP survey remain elevated but likely reflect expected pass-through of indirect effects rather than strong second-round effects.

The absence of evidence of second-round effects tells us something, but not much. It is likely still too early to see evidence in the data, especially given that indirect effects are coming through more slowly than expected.

Where the economy was pre-conflict is relevant. Inflation has been above target for much of the past five years, leading to households and firms being more attentive to inflation than in the past. This means that inflation expectations could respond more strongly to any near-term increase in inflation. There is mixed evidence for this in the recent data, but this could change as headline inflation continues to rise in the months ahead. On the other hand, weak domestic pricing power and limited underlying wage pressure could limit the extent of second-round effects. Different views on the size and importance of these factors account for some of the differences in policy views across MPC members.

The size and persistence of the energy shock matter for second-round effects because they shape the direct and indirect inflation impulse and the time available for expectations and wage-price setting to respond. But, as Megan Greene (Greene (2026)), Alan Taylor (Taylor (2026)) and Huw Pill (Pill (2026)) have each illustrated, the relationship is not mechanical: persistently high energy prices need not generate strong second-round effects, and strong second-round effects need not require exceptionally high or persistent energy prices.

My own take is that circumstances have changed since July. The conflict has continued with consequences for the level and volatility of energy prices. Energy prices have evolved more in line with the adverse scenario whereas their second-round effects look more like the treatment in the central case. So I now put higher weight on us being closer to the adverse scenario for energy prices than I did in July. The stronger treatment of second-round effects in the adverse scenario still seems less likely than those captured in the central case. With the weaker indirect effects observed so far supporting that view. This means even if energy prices continue to sit closer to the adverse scenario, the policy consequences of that are not a forgone conclusion. That said, I continue to think it most likely that second-round effects and energy prices are positively related so the risk of material second-round effects has risen the longer higher energy prices are visible in prices people observe.

The monetary policy response

Monetary policy cannot change global energy prices; our task is to prevent the shock from generating persistent inflation without imposing undue costs on activity. That means looking through direct effects. These cannot be tackled with monetary policy as energy price volatility affects inflation more quickly than monetary policy can respond, given it impacts the economy with a lag. This principle is symmetric. If energy prices were to fall back and their contribution to inflation were eventually to turn negative, monetary policy should equally look through that temporary weakness and focus on returning inflation sustainably to the 2% target in the medium term.

The response to indirect effects depends on the shock: they can often be looked through when modest or temporary but may require tighter policy when large and persistent because prolonged pass-through raises the risk of second-round effects. Finally, monetary policy should lean strongly against second-round effects, which risk de-anchoring inflation and preventing it from returning sustainably to target.

Judging the likely extent of second-round effects in real time is difficult. We should learn more in Q4 as information on price and wage expectations arrives, although the evidence may still not be conclusive. There is little in the data so far to suggest that second-round effects are large, but it is too soon to tell.

The change in the policy outlook since before the conflict has been significant. Prior to the conflict, the Committee was gradually reducing monetary restriction as domestic inflationary pressures eased. That process was gradual because domestic disinflation itself was gradual and remained vulnerable to further inflationary shocks. We had reduced rates by 150 basis points since their peak, pausing at 3.75% when the conflict broke out. Since then, Bank Rate has remained unchanged and financial conditions have tightened materially. For example, quoted rates on two-year fixed-rate mortgages are now more than one percentage point higher than prior to the conflict. Current monetary and financial conditions are restrictive and are already leaning against inflationary pressures.

Different MPC members will naturally place different weight on different pieces of evidence, as reflected in their individual paragraphs and speeches. But the MPC shares an analytical framework for thinking through the implications of the energy shock for inflation and monetary policy. That framework provides a disciplined way of learning and updating our judgements as new information arrives.

To date, a majority of the MPC have not judged that an increase in Bank Rate is needed but, as outlined in the September minutes, have noted that the inflation risks are currently to the upside and waiting for evidence had limits. Financial market participants have looked at the same information and reached a broadly similar conclusion about the balance of risks, assigning a greater probability to states of the world that require higher policy rates in the near term.

There is uncertainty not just about the next move, but the path beyond. We are in a very different place from the tightening cycle of 2021/22. Then policy rates started at the historically low level of 0.1% and policy was highly accommodative. Today Bank Rate is 3.75% and overall financial conditions are leaning against inflationary pressures in the economy. Decisions beyond the next meeting will depend on how energy prices evolve and how the shock propagates through the economy. On both questions we will learn more over the coming months. This is reflected in market pricing: the option-implied probability distribution for future interest rates has widened since our July Report.

I will conclude with my views on the policy outlook. There remains material uncertainty about the size and duration of the shock and how it will pass through the economy. We are learning about the impacts. What we have seen so far shows the direct pass-through to inflation has been broadly as anticipated. Activity has been stronger – both the underlying economy and the response to the shock. Yet to date indirect effects have been more limited than expected.

This gives pause for thought. Firms have shown a surprising ability to absorb higher energy prices to date, but this ability will be limited. If elevated energy prices persist for long enough, direct cost pressures are increasingly likely to eventually turn into indirect and second-round inflationary pressures. The relevant question is therefore not whether we can already observe indirect and second-round effects in the data, it is whether the conditions for those indirect and second-round effects are becoming more entrenched. The longer higher energy prices persist, the greater the risk that indirect effects build and that inflation expectations, wage bargaining and price-setting behaviour begin to adjust in response.

On that basis, policy is increasingly likely to need to tighten if elevated energy prices persist, absent clear evidence of disinflation or weaker activity. But this is by no means suggesting that monetary policy should respond mechanically to movements in energy prices. The key issue is not the spot price of energy itself but the interaction of the underlying economy, higher energy prices, and the nature of their transmission. That, ultimately, is what will determine whether Bank Rate needs to rise.

I would like to thank Lukas von dem Berge and Brad Speigner for their help with preparing this speech. I also thank Carleton Webb, Michal Stelmach, Alex Kontoghiorghes, Amarjot Sidhu, Giulia Gardin, Tim Willems, Tim Munday, Neha Jain and Marcus Buckmann for their help with data and analysis. And Jamie Bell, Fergal Shortall, Becky Maule, Rohan Churm, Geoff Coppins, Sean Maloney, Chris Duffy, Catherine Mann, Huw Pill and Sarah Breeden for their helpful comments on earlier drafts.