Oil prices lurched upwards again on Thursday, creating a growing headache for UK policymakers ahead of John Healey’s budget next month.
While Healey has been keen to present an upbeat picture of the UK’s economic prospects, Treasury sources concede the sharp jump in oil and gas prices means they have “less room” than a month ago.
Officials are working “at pace” on a range of possible options for supporting consumers, particularly if high prices persist, feeding through into a sharp rise in the quarterly energy price cap in January.
But any package is expected to fall far short of the costly across-the-board subsidies announced by Liz Truss in 2022, with the Treasury mindful of the measures already taken, including Andy Burnham’s VAT cut on electricity bills.
Options are believed to include shifting more green subsidies into general taxation, echoing the approach taken by Rachel Reeves, or targeting help at the poorest households – though some officials are sceptical about how effectively this can be achieved.
The price of a barrel of Brent crude was up almost 5% at $108 on Thursday after reports of more military clashes between Saudi Arabia and Houthi forces.
Donald Trump has given little indication of how, or when, the wider US-Israeli war on Iran could be brought to a close, despite the impact on gasoline prices in the US before crucial midterm elections.
Senior UK government figures are also increasingly concerned about the prospect of interest rate rises, which could push up the cost of a mortgage just as Burnham has promised voters “breathing space”.
After leaving interest rates on hold at 3.75% last week, the Bank of England said it expected the energy price cap to rise by as much as 24% in the new year.
The Bank’s chief economist, Clare Lombardelli, said in a speech on Thursday that the longer oil prices remained elevated as a result of the war, the more likely it was that rates would have to rise.
“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,” she told an economic conference in Warsaw, Poland. “On that basis, policy is increasingly likely to need to tighten if elevated energy prices persist, absent clear evidence of disinflation or weaker activity.”
Lombardelli’s warning was echoed by another member of the Bank’s monetary policy committee, the deputy governor Sarah Breeden, who told a conference at Imperial College London: “The larger and longer the shock, the more likely it is that we’ll see the material second-round effects that policy needs to respond [to].”
Expectations of higher inflation and interest rates caused by rising energy prices are a key factor driving the global selloff in government bond markets – raising the cost of borrowing for the UK, alongside other economies.
The yield – in effect the interest rate – on 10-year UK bonds, known as gilts, rose to 5.39% on Thursday, approaching the 19-year high set last week.
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Higher interest rates raise the upfront cost of government investment and feed through into Office for Budget Responsibility forecasts of whether the chancellor is on course to meet Labour’s fiscal rules.
Analysts believe recent increases in yields have wiped out more than half of the £24bn “headroom” against the rules that Reeves had built up at the time of the spring statement in March.
Healey has repeatedly promised to meet the rules with a “buffer against uncertainty” but this is widely expected to be significantly lower than £24bn. Rebuilding it to that level would be likely to require large tax increases or spending cuts, but Treasury sources insist the budget will be narrowly focused.
Investors across the main markets have been ditching bonds in recent weeks in a wave of selling, as the conflict in the Middle East rumbles on. As the bond sell-off continued to worsen on Thursday, yields on 10-year US treasury bonds surged to 5.17%, the highest level since 2007.
Alongside higher inflation, investors appear to be concerned about the risks of uncontrolled US government spending. Some analysts also suggest large-scale bond issuance by AI firms is undermining demand for treasuries.