By David Milliken
LONDON, July 27 (Reuters) - The Bank of England looks set to keep interest rates unchanged at 3.75% on Thursday, despite a recent spike in oil prices above $100 a barrel which may test whether it can avoid raising borrowing costs in response to the U.S.-Iran conflict.
So far, British inflation has come in below the BoE's forecasts, dropping to a 15-month low of 2.6% in June.
A lag in how regulated domestic energy prices respond to higher wholesale costs means Britain now has lower
inflation than the United States and the euro zone, where the European Central Bank looks likely to raise rates for a second time this year in September or October.
MARKETS AND ECONOMISTS SPLIT OVER BOE OUTLOOK
A BoE rate rise would be a blow for new Prime Minister Andy Burnham, who has pledged a renewed focus on lowering the cost of living. He will also have to wrestle with higher borrowing costs in his government's first annual budget in the autumn.
Neither economists polled by Reuters nor financial markets see any real chance of a rate rise by the BoE this week, but there is a sharp split on the longer-term outlook.
After last week's rise in oil prices, interest rate futures moved to price in a two-in-three chance of a quarter-point BoE rate rise in September and almost three moves by next June.
Even after a fall in oil prices to $90 a barrel on Monday, markets still fully priced in a rate hike by November.
But only a handful of economists expect a hike this year.
Henry Cook, a senior economist at Japan's MUFG, scrapped a previous call that the BoE would make a precautionary rate rise similar to the ECB.
"We've had three downside surprises now in a row on inflation and plenty of signs of slack within the labour market," he said.
In April, the BoE forecast inflation would peak at around 3.6%-3.7% at the end of 2026 under two of its three scenarios for oil prices and other economic developments, but in June it revised that down to just over 3.25%.
Oil futures are still in line with the mildest of the BoE's three scenarios, and the futures curve for natural gas prices — which hit a four-month high last week — is close to the middle scenario.
UK INFLATION STUCK ABOVE TARGET
Nonetheless, British inflation has been above its 2% target for most of the past five years.
BoE Chief Economist Huw Pill — who voted for a rate rise in April and June — fears a second oil price shock in four years could make households and businesses expect higher inflation for years to come.
But Governor Andrew Bailey has said the BoE does not need to raise rates like the ECB because it had cut them by less before the Iran war started at the end of February.
British mortgage rates and business borrowing costs rose almost immediately when the BoE made clear in March that rate cuts previously expected in 2026 were unlikely.
On Thursday, Bailey is likely to stress that the BoE will keep a keen eye on increases in wages and prices not directly linked to higher energy prices.
Household and business inflation expectations rose sharply at the start of the conflict but recent data, including on wages, has offered some grounds for relief.
QT REVIEW
The BoE is likely to publish an analysis of how its bond sales programme affects markets ahead of an annual MPC vote on its pace in September.
Last year, the BoE slowed the pace of quantitative tightening to £70 billion ($93 billion) a year from £100 billion and skewed sales towards shorter-dated bonds. A BoE survey in June showed markets expect QT to slow further to £50 billion.
Before last year's decision, the BoE estimated that QT had added 0.15-0.25 percentage points to long-term gilt yields, but research published by the central bank in May pointed towards a 0.4 percentage point impact.
University of Liverpool professor Costas Milas, a co-author of the latest research, said the BoE might need to reconsider the pace of sales but should not stop QT entirely.
"If we just ignore QT or pause QT ... perhaps the BoE might have to raise Bank Rate earlier than it possibly has in mind," he said.
($1 = 0.7505 pounds)
(Reporting by David Milliken; Editing by Kirsten Donovan)
