Key Takeaways
- Energy inflation from the Strait of Hormuz closure should be short-lived.
- UK rate hike expectations seem “overdone,” echoing 2022 post-Ukraine invasion fears.
- The global economic outlook is highly uncertain, especially for energy price recovery.
Ollie Smith: Now, for the second time in just over 12 months, global economic expectations have been upended—and not, it must be said, by tariffs, but by war in the Middle East. In terms of the UK impact, some economists are more sanguine than others, and one of them joins me on the line now. Grant Slade is Morningstar’s international economist, and he joins me from Amsterdam. Grant thanks so much for your time.
I think some commentators might be surprised to see you use the word “transitory” in your assessment of UK inflation outcomes. Can you tell us a little bit more about that? Why are you so confident that it will be short-lived?
How Long Will the UK Inflation Spike Last?
Grant Slade: Yeah, absolutely. Thanks for the question, Ollie, and good to be with you today. It’s certainly fair to say that the outlook for inflation over coming quarters is highly dynamic, and will be contingent on how long the conflict in the Middle East plays out over the coming weeks, [and] possibly months. However, it’s important to remember that supply-side shocks, such as the one that we’re currently going through at the moment with energy prices, are indeed transitory by nature.
So the supply of oil and gas has been quite significantly impacted by the conflict. However, this supply disruption is likely to be temporary, with energy supply from the region likely to gradually normalize as the conflict subsides. And we see that expectation reflected in the current shape of futures curves for energy markets, where prices are expected to peak mid-year and then recede gradually thereafter.
And that, of course, means that, while inflation is set to spike near-term, we’ll actually see it start to begin to see a subsequent disinflationary impulse throughout 2027, and as we move into 2028, as energy prices fall back again once more. So the magnitude and the likely duration of the energy price spike is certainly a major point of difference versus what we saw in 2022, for example. There’s also a number of other, I guess, key differences versus that experience with the outbreak of the conflict in Ukraine in 2022, when we saw inflation in the UK at multidecade highs—the memory of which remains very much in the rearview mirror of investors.
How Likely Is a UK Recession in 2026?
Smith: Sure. And just in terms of what happened at that time, I mean, there was a brief recession in the UK after that occurred. I just want to ask you how likely, in your view, is a recession in the UK?
Slade: Yeah, absolutely. So, look, at this point in time, we’re not calling for a recession near-term. We think, in particular, the need for the Bank of England to respond to the Middle East conflict with higher interest rates is significantly reduced relative to the 2022 situation. Back then, we obviously saw inflation rise above 10%. Interest rates, as a result, were lifted 500 basis points over the course of 2022 [and] through 2023, moving the bank rate into very restrictive territory.
However, this time around, we certainly think that the Bank of England will mostly be able to look through the temporary inflation spike over coming quarters. After all, raising UK interest rates does nothing to clear the bottleneck in the Strait of Hormuz or to bring oil and gas infrastructure in the region that has been impacted and bring that back online. So, as a result, the UK economy is likely not to face the level of restrictiveness, in terms of financial conditions, that it did postpandemic. So that really greatly reduces the risk of a hard landing this time around.
Are Markets Overestimating Bank of England Rate Hikes?
Smith: Sure. So what, in your view, explains the behavior of interest rate swaps markets? Because we’ve gone at the start of the year from them forecasting, you know, between one and two rate cuts in the UK. They’re now forecasting two rate hikes and possibly more. What actually explains that swing?
Slade: Yeah, absolutely. So, look, since the beginning of the conflict in the Middle East, we’ve seen some really wild movements in swap markets. As you pointed out, you know, preconflict, we had two rate cuts being fully priced in by swap markets. And we saw those expectations as reasonable given that inflation had continued on its downward path. In early 2026, private sector wage growth has also slowed appreciably since late last year, and the labor market has obviously weakened as well as of late last year, with unemployment now at around 5.2% versus its longer term trend of around 4.5%. Now, if we are to start to talk post-oil shock swap markets are now pricing in numerous rate hikes by year end. So it’s really quite a dramatic reversal that we’ve seen there. And that reversal of expectations really we think reflects two things.
First of all, the quite substantial uncertainty as to when the conflict may end and therefore when energy prices may begin to normalize again. Bearing in mind, obviously, the longer that energy prices remain high, the steeper the spike we’ll see in inflation in the UK and coming quarters. So, the swap market reaction partly reflects that uncertainty.
But we think more broadly investors’ expectations as to how the Bank of England may respond to the now-inevitable, spike that we’ll see in inflation in coming quarters, on that experience that we’re just talking about previously, of the prior energy shock in 2022 when Russia invaded Ukraine. So, you know, you will you’ll likely remember that the outbreak of that conflict obviously sent natural gas prices soaring. They rose as much as 500% in 2022. The market priced in that structural withdrawal of Russian natural gas supply. So there’s likely also, a recency bias element to what’s being reflected in the swap market. And we think that investors here are reacting in a very zealous, once bitten, almost twice shy, kind of manner. But despite, I guess, that uncertainty that surrounds the Middle East situation, there are certainly reasons to think that, what is currently baked into the swap prices is overdone, and supreme among those is the reality that, the energy price spike that we’ve seen is obviously significant, but it’s nowhere near as severe as what we obviously saw in 2022.
Secondly, the UK economy has significantly more slack than it did back in 2022. And, so that should further certainly attenuate the extent to which the Bank of England may need to respond to address that temporary inflation spike. So the situation is quite different to the one that we saw in 2022.
Smith: Grant, thanks so much. For more on the global economic fallout from conflict in the Middle East, be sure to check out any of Morningstar’s editorial websites internationally, where you can sign up for our revamped editorial newsletters.
For now, we are just about out of time, but my thanks to Grant, I’ve been Ollie Smith for Morningstar.
