Energy pressures and a renewed hiking impulse

The third quarter was shaped by the interaction of a prolonged energy supply shock, resilient economic activity and increasingly differentiated central-bank responses.

The conflict in the Middle East remained the principal source of macroeconomic uncertainty, with renewed hostilities and constrained shipping through the Strait of Hormuz preventing a sustained normalisation of energy supplies. By early September, Brent futures were trading around $105 per barrel, approximately $21 higher than at the start of August, while disruptions to refining capacity pushed the prices of diesel and other refined products higher still. The economic consequences extended beyond the immediate increase in headline inflation: higher transport and production costs put pressure on corporate margins and household purchasing power, while the duration of the shock raised concerns about its eventual transmission into wages and broader price-setting.

Nevertheless, the global economy continued to absorb these pressures better than initially anticipated. Investment associated with artificial intelligence supported capital expenditure, industrial production and technology trade, while services activity and consumer spending remained comparatively resilient.

These sources of demand helped offset the drag from higher energy costs, although the benefits were unevenly distributed across countries and sectors. In September, the OECD1 projected global growth of 2.9% in 2026, while warning that a more persistent energy shock would increasingly erode real incomes and weigh on activity. For monetary policy, this created a difficult combination: growth remained sufficiently firm to sustain inflation concerns, but additional tightening risked amplifying the eventual slowdown caused by the supply shock.

Global monetary policy remained focused on persistent inflation, although the policy response increasingly diverged across regions. The Federal Reserve and European Central Bank (ECB) both raised rates by 25 basis points in September as resilient activity provided scope to address continued inflation pressures. By contrast, the Bank of England held rates unchanged, balancing above-target inflation against softer labour market conditions and easing wage pressures. Looking ahead, further policy decisions are likely to remain data dependent, with inflation persistence, labour market conditions and growth resilience determining the pace and extent of any additional tightening.

The eurozone combined improving activity indicators with renewed upward pressure on headline inflation. Annual inflation increased from 2.8% in June to 2.9% in July and 3.2% in August, with energy making a larger contribution. The final August reading was revised down from the initial 3.3% estimate, but the direction remained higher. Underlying pressures were more contained: core inflation eased to 2.4% in August, while services inflation declined to 3.0%. The distinction between an immediate energy-price shock and a more persistent inflation problem remained central to the policy outlook.

Economic activity was more resilient than had initially been expected. Data released on 7 September showed Q2 GDP increasing 0.6% quarter-on-quarter, although a substantial rebound in Ireland contributed to the aggregate result and meant that the headline should not be interpreted as an equally strong expansion across member states. More timely indicators suggested an improvement towards quarter-end. September’s flash composite PMI increased to 53.1 from 52.0, with services strengthening and manufacturing continuing to expand. Germany’s Ifo business-climate index also improved. These developments reduced the immediate emphasis on downside growth risks, even as the surveys signalled renewed cost pressures.

The ECB left rates unchanged in July before increasing all three key policy rates by 25 basis points on 10 September. The deposit facility rate rose to 2.50%, effective from 16 September. The Governing Council linked the decision to continuing inflation pressure from the Middle East conflict and the prospect of inflation remaining above target for an extended period. Its revised projections showed headline inflation averaging 3.0% in 2026, 2.5% in 2027 and 2.1% in 2028.

Growth projections were also revised higher for 2026 and 2027, reflecting greater economic resilience than previously assumed.

Nevertheless, the September increase did not establish an automatic sequence of further moves. The ECB retained its data-dependent, meeting-by-meeting approach, with the subsequent debate focused increasingly on the pace of tightening. In her 28 September remarks, Christine Lagarde emphasised a measured response and distinguished the higher headline inflation outlook from evidence of entrenched second-round effects. Markets expected further action, while allowing policymakers time to assess the transmission of the energy shock.

The United Kingdom’s third-quarter experience was characterised by a widening tension between renewed headline inflation and more subdued underlying domestic pressures. Inflation initially provided some reassurance, with the June consumer price index (CPI) reading falling to 2.6% year-on-year, but this improvement subsequently reversed. Headline inflation increased to 2.9% in July and 3.1% in August, with motor fuels making the largest contribution to the latest acceleration. The composition remained important, however: August core inflation was unchanged at 2.6%, while services inflation remained at 3.4%. The data therefore showed a renewed external cost shock without a corresponding acceleration across these underlying measures.

Labour-market conditions continued to provide a counterweight to the inflation risks. Unemployment stood at 4.9% in the three months to July, while administrative payroll data indicated continued weakness in employment. The provisional estimate showed a further 26,000 decline in payrolled employees in August, following a fall in July. This suggested that labour demand remained soft, although the latest payroll figures were subject to revision. For the policy debate, the significance was that firms were facing higher energy costs in a less buoyant employment environment, potentially limiting the extent to which those costs would translate into stronger wages and sustained domestic price increases.

Growth data were firmer than the labour-market picture alone implied. The national accounts published on 30 September revised Q2 GDP growth to 0.5% quarter-on-quarter, from an initial estimate of 0.4%. More timely surveys pointed to continued expansion, although momentum softened towards quarter-end. September’s flash composite PMI declined to 51.7 from 52.5 in August, while the survey also reported renewed input-cost pressure. The overall picture was therefore one of modest economic expansion rather than an outright contraction, but with businesses continuing to face an uncomfortable combination of slower activity growth and higher costs.

The Bank of England maintained Bank Rate at 3.75% at both its July and September meetings, each time by a 6–3 majority. Megan Greene, Catherine Mann and Huw Pill preferred an increase. The majority continued to see soft labour-market conditions and restrictive financial conditions as important restraints on inflation, while acknowledging that the risk of broader effects on wages and prices would increase the longer the energy shock persisted. September’s decision was therefore a conditional hold, not a signal that further tightening had been ruled out.

Fiscal signalling added term premium through late July. The 10-year gilt moved higher by around 8bps on the day of the Prime Minister's first remarks on fiscal flexibility and, together with the Bank's conditional hold, left the sterling curve pricing a further 25bp hike by December and a cumulative 100bps or so by mid-2027.

The U.S. economy continued to demonstrate resilience during the third quarter, reducing the urgency for the Federal Reserve to provide policy support. Consumer spending and business investment remained important sources of strength, particularly investment associated with technology and artificial intelligence. The national accounts released on 30 September revised Q2 GDP growth to an annualised 2.2%. Underlying private demand was stronger than the headline alone suggested: real final sales to private domestic purchasers, which combine consumer spending and private fixed investment, increased at an annualised 4.6%. These figures reinforced the view that domestic demand was continuing to absorb elevated financing costs.

The labour market presented a more nuanced picture. Hiring had been subdued earlier in the summer, but the August employment report showed an increase of 162,000 nonfarm payrolls, while unemployment remained at 4.1%. Upward revisions left June and July employment gains at 31,000 and 21,000, respectively. The stronger August result therefore followed a relatively weak period rather than establishing an uninterrupted acceleration in hiring. Nevertheless, the stability of unemployment gave policymakers limited evidence of an immediate deterioration severe enough to outweigh their inflation concerns.

Inflation remained the principal constraint on the policy outlook. The personal consumption expenditures release published at quarter-end, incorporating the annual statistical update, showed August headline personal consumption expenditures (PCE) inflation at 3.4% year-on-year and core inflation at 3.0%. Monthly increases were more contained, at 0.3% and 0.2%, respectively, but both annual measures remained above the Fed’s objective. At the same time, real consumer spending increased 0.6% over the month, illustrating why softer monthly inflation readings did not necessarily imply a meaningful weakening in demand.

The change in Federal Reserve communication developed progressively through the quarter. On 29 July, the Federal Open Market Committee (FOMC) maintained the target range at 3.50%–3.75%, although three members preferred an immediate increase. At Jackson Hole on 28 August, Chair Kevin Warsh acknowledged that some summer inflation readings had been better than expected but argued that they had not yet demonstrated a convincing improvement in the underlying trend. His remarks placed particular emphasis on the breadth and persistence of price increases, rather than treating the inflation challenge solely as a temporary movement in energy prices.

On 16 September, the FOMC unanimously increased the target range by 25 basis points to 3.75%–4.00%, citing solid activity and persistently elevated inflation. The accompanying projections showed a median year-end federal funds rate of 4.1%, consistent with another quarter-point increase, and the same median rate for end-2027. These were policymakers’ assessments of appropriate policy, rather than a commitment to a predetermined sequence of moves, but they indicated an expectation that restraint would need to be maintained.