Lessons from the last energy shock

The war on Iran has pushed energy prices higher once again, reviving fears of another inflation shock. The escalation of the conflict has already disrupted global energy markets, with supply losses on a scale comparable to, or even exceeding, past major energy crises. This comes just as the UK was recovering from the last price spike. Prior to the war, inflation was expected to return to the 2% target by April.

With the Bank of England approaching its next interest rate decision tomorrow, the UK needs to learn the right lessons from the last energy crisis and not rely on interest rate hikes as the main way of controlling energy-driven inflation. Rate hikes are not only slow and untargeted, but also actively undermine the clean energy investment needed to reduce our long-run vulnerability to fossil fuel shocks.

Rates are more likely to be hiked if inflation appears persistent after the main shock has subsided. But the last crisis shows us that lingering price increases are often temporary after-effects of the initial shock. For example, other sectors that use energy as an input may take some time to adjust to falling energy inflation. And wage increases that push up costs in labour-intensive sectors may simply be catching up to the shock-induced price increases. These effects may temporarily prolong the inflationary effect of the shock, but can subside without need for interest rate rises that push up mortgage costs and squeeze household finances unnecessarily.

The last inflation surge demonstrated how energy shocks do not stay confined to energy, but instead have impacts across the economy which can take some time to subside even after the shock has passed. What begins as a rise in fuel and electricity costs feeds into food, goods and ultimately services. Even after the direct initial shock fades, prices keep rising across a broad range of sectors. Much of what appears to be persistent inflation reflects the delayed effects of an earlier energy shock.

Figure 1: Food and services inflation lagged behind increases in energy prices, and have been slower to come down

Source: Author’s calculations using Office for National Statistics CPIH data, using CDIDs L550, L5KT, L5KY, L5L3, L5LC and corresponding weights.
Note: ​‘Other’ includes services and remaining CPIH components not shown separately .

The dynamic is visible in Figure 1. The surge in inflation in 2021 and 2022 was driven by sharp increases in energy prices, alongside a rise in core goods inflation as firms passed on higher input and distribution costs. Food inflation followed, as higher costs fed through more gradually. But as energy price increases subsided in early 2023, price increases in other sectors were slower to come down. What began as an energy shock became an economy-wide inflation episode.

Notably, services inflation remained elevated, with services inflation at 4.3% in January 2026. Services inflation is a key indicator used by the Bank to determine whether external shocks to prices have led to inflation becoming embedded in the UK economy, because it is a labour-intensive sector where high wages could feed through to high prices – which in turn could lead workers to bargain for higher wages, triggering a wage-price spiral. However, this persistence does not necessarily reflect a self-sustaining wage-price spiral, despite many policymakers interpreting it as such.

Figure 2: Nominal wages grew more slowly than prices between the start of the energy crisis, only catching up by mid-2024

Source: Author’s calculations using Office for National Statistics average weekly earnings and CPIH data.
Note: Series are indexed to January 2022 = 100 to show cumulative changes in wages and prices since the early stages of the energy shock.

Figure 2 makes this clear. Prices rose sharply following the energy shock, while nominal wages initially lagged behind, reflecting a significant real income squeeze. Over time, wages began to catch up with earlier price increases.

Wage growth is now levelling out: in the three months to February, it was the lowest it has been since November 2020. In its latest monetary policy report, the Bank of England projects wage growth returning to inflation-target-consistent levels over the course of 2026. This pattern suggests that elevated services inflation over 2023 – 25 reflects a process of wage adjustment, rather than a self-sustaining wage-price spiral. As monetary policy committee member Alan Taylor has argued, this catch-up wage growth was a natural after-effect of the initial price shock. Wage rises began to slow in late 2024 into 2025, after they had somewhat caught up to prices. In his view, this means that interest rates didn’t need to be kept as high as they were, stating that he would have preferred them to have remained lower to prevent rising unemployment. Unemployment recently rose to a peak of over 5%.

This reveals a mismatch between the drivers of inflation and the tools used to control it. The UK’s macroeconomic framework is built to manage demand cycles, not repeated external supply shocks. In fact, a recent IMF report shows that countries that raised interest rates more sharply after the 2022 inflation surge did not see better results in bringing inflation down. By relying on interest rates, policymakers are using demand-side tools to manage what is fundamentally a supply-driven shock. Monetary policy can dampen demand, but it cannot lower global oil and gas prices or prevent supply disruptions. By the time higher interest rates take effect, the shock has already fed through to prices, costs and wages across the economy, and these effects are often temporary.

If inflation is being driven by energy shocks, then policy must focus on containing the impacts directly. This means limiting how energy costs are passed on to households, while also minimising price gouging along supply chains.

This could include an essential energy guarantee that fixes a low cost basic amount of energy for all households, while charging more to heavier consumers. It also points to a larger role for public coordination in energy markets — including long-term procurement contracts, strategic stockpiling, and reforming the wholesale market to decouple renewable electricity prices from the cost of gas​.At the same time, when firms pass on cost increases, and sometimes magnify them, specific shocks get amplified into more systemic inflation. Policies that prevent opportunistic price-gouging can limit this process.

These interventions do not eliminate the shock itself, but they can contain how it spreads through the economy. By contrast, relying primarily on interest rate rises means responding only after the shock has already fed through to prices and costs, placing the burden on households rather than addressing the source of the problem. What is more, raising interest rates actually makes it more expensive to finance clean energy technologies, reducing the very investments that are needed to reduce the economy’s vulnerability to fossil fuel shocks.

The UK remains highly vulnerable to global energy price movements, particularly through its reliance on gas. As long as the economy remains dependent on fossil fuels, external price shocks will continue to be the greatest threat to domestic price stability. Reducing that exposure is therefore not just a climate objective, but a core macroeconomic priority. This requires sustained investment in domestic renewable energy supply, improved energy efficiency, and electrification.

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