The UK government and the Bank of England have indicated that it is premature to fully assess the economic impact of the Iran war. However, early signs of strain are emerging, raising concerns among policymakers who now face more limited tools than in previous crises. On Thursday, the Organisation for Economic Co-operation and Development (OECD) downgraded the UK’s growth forecast for 2026 more sharply than for any other major economy, while simultaneously increasing the inflation forecast by the largest margin.
This grim outlook threatens the Labour government’s key promise to voters that it could restore public finances and improve public services through accelerated economic growth. It also jeopardizes the Bank of England’s goal of taming high inflation for the first time in several years.
Among major Western economies, the UK is particularly vulnerable due to its reliance on gas, which has nearly doubled in price this month. Gas typically determines electricity prices in the UK, unlike in France where nuclear power predominates. Recent surveys revealed the largest month-to-month increases in decades in public inflation expectations and manufacturing cost gauges, alongside a decline in consumer confidence.
Households have begun to feel the price increases, notably at fuel pumps, while farmers warn of rising food costs starting next month, particularly for tomatoes, cucumbers, and peppers grown in heated greenhouses. Retailers expect the conflict to push up their costs and selling prices while dampening demand. Clothing retailer Next cautioned that a prolonged war could increase its prices by 2% in June and up to 10% later in the year. The Co-op, a food-to-funerals group, described consumer confidence as “fragile.” Meanwhile, in the housing market, floating mortgage rates are rising and lenders have withdrawn fixed-rate products in anticipation of further Bank of England interest rate hikes.
Ross Walker, chief UK economist and head of global economics at NatWest Markets, noted that Britain has limited capacity to counter a prolonged energy crisis. The government cannot borrow extensively to support households without alarming bond investors, while inflationary pressures remain too high for the Bank of England to reduce rates quickly, despite rising unemployment. Walker stated, “We enter this crisis in a suboptimal position. Policy leeway looks very constrained.”
In a significant development, the Bank of England recently affirmed its readiness to act to prevent the energy price surge from triggering persistent inflation similar to that following Russia’s full-scale invasion of Ukraine in 2022. However, officials caution against repeating the same approach used four years ago, when interest rates were raised from near zero to a peak of 5.25% within 18 months. They argue that the risk of energy costs causing broader inflation may be lower this time due to the UK economy’s current weakness and a less dramatic gas price increase.
BoE rate-setter Megan Greene remarked, “There’s always a risk of fighting the last battle, but we’re certainly doing what we can.” Conversely, Stephen Millard, deputy director of the National Institute of Economic and Social Research, suggested that memories of inflation surging above 11% in 2022 will make it difficult for the Bank of England to remain passive. He predicted that the central bank will likely need to respond.
Nonetheless, with the Bank of England’s benchmark lending rate at 3.75% and unemployment at its highest since the COVID-19 pandemic, the scope for multiple rate hikes to combat severe inflation appears more limited than four years ago. Investors are now fully pricing in three quarter-point interest rate increases this year, a sharp reversal from the two cuts they anticipated just a month ago. However, most economists surveyed expect the Bank of England to maintain rates in 2026.
Finance Minister Rachel Reeves also faces constrained options compared to her predecessors, who collectively spent £120 billion ($160 billion) to shield households from job losses during COVID-19 and the energy price surge after the Ukraine invasion. Public debt, already historically high at 83% of GDP before the pandemic, now stands at 93%. Reeves emphasized that any consumer support would be targeted at “those who need it most,” mindful of investor concerns about the cost of another large bailout.
Analysts at Capital Economics estimate that potential baseline tax cuts and one-off payments from Reeves could total £24 billion, less than half the support provided in 2022 and 2023. Millard noted that while Reeves has some room to assist households, it must be done carefully to maintain bond market confidence. He stressed, “The key is she needs to make sure that the support she provides is targeted at those people that really need it. She’s also got to make sure that they don’t endanger their fiscal rule, because if they do, then the markets I think would react quite badly.”
