UK economy shows first hits from Iran war

The UK’s government and the Bank of England say it is too soon to judge the economic hit from the Iran war, but the first strains are ​appearing and are likely to ring alarm bells for policymakers whose response options are more limited than in past crises.

On Thursday, the Organisation for Economic Co-operation and Development cut the UK’s growth ‌forecast for 2026 by more than any other major economy and raised the country’s inflation forecast by the most too.

The bleak outlook jeopardises the Labour government’s central pledge to voters that it could fix the public finances and pay for better public services with faster economic growth.

It also threatens the Bank of England’s hopes of bringing high inflation under control for the first time in years.

GAS DEPENDENCE MAKES UK MORE VULNERABLE

While much of the global economy will feel the effects of the conflict, UK  is particularly vulnerable ​among big Western economies.

Gas – which has almost doubled in price this month – typically sets the price for UK electricity, unlike in France, where it is mostly generated by nuclear plants.

Surveys this week showed the ​biggest month-to-month leaps in decades in the UK public’s inflation expectations and in a gauge of costs paid by manufacturers, alongside falls in consumer confidence.

The first clear increase in prices ⁠paid by households has been felt by drivers at the fuel pumps, while farmers have warned of higher food prices from next month, starting with tomatoes, cucumbers and peppers, which are grown in heated greenhouses.

Retailers say ​the war will raise their costs and selling prices, as well as hitting demand. Clothing chain Next warned a long conflict could push up its selling prices by 2% in June and up to 10% later in the year.

Food-to-funerals ​group the Co-op said consumer confidence was “fragile”. In the housing market, floating mortgage rates are jumping and lenders have pulled fixed rate products anticipating higher BoE interest rates.

Ross Walker, chief UK economist and head of global economics at NatWest Markets, said Britain had limited firepower to counter a lengthy energy crisis.

The government cannot borrow heavily to help households without upsetting bond investors, while underlying inflation pressures were already too high for the BoE to cut rates quickly, despite a rise in unemployment.

“We enter this crisis in ​a suboptimal position,” Walker said. “Policy leeway looks very constrained.”

DON’T FIGHT THE LAST BATTLE

The BoE last week said it was ready to act to prevent the energy price spike from turning into the kind of long-lasting inflation problem ​that followed the surge in gas prices when Russia launched its full-scale invasion of Ukraine in 2022.

However, policymakers are warning against assumptions that they will follow their approach of four years ago. Then, they raised borrowing costs from almost zero to ‌a peak ⁠of 5.25% in the space of 18 months.

BoE officials say the risks of higher energy costs causing broader inflation might be lower this time because Britain’s economy is weaker now. Furthermore, the jump in gas prices has so far been less dramatic.

“There’s always a risk of fighting the last battle, but we’re certainly doing what we can,” BoE rate-setter Megan Greene said on Wednesday.

But Stephen Millard, deputy director of the National Institute of Economic and Social Research think-tank, said memories of the surge in inflation to above 11% in 2022 would make it harder for the BoE to sit tight and do nothing.

“I think almost certainly, it is going to have to respond,” Millard ​said.

However, with the BoE’s benchmark lending rate already at ​3.75% and unemployment at its highest since the ⁠COVID pandemic, the scope for several borrowing cost increases to tackle a severe inflation outbreak looks smaller than four years ago.

Investors are fully pricing three quarter-point interest rate hikes by the BoE this year, a sharp reversal from the two cuts they were predicting a month ago. By contrast, most economists polled by Reuters think it ​will stay on hold in 2026.

LIMITED SUPPORT OPTIONS FOR REEVES

Finance minister Rachel Reeves’ options are also more limited than they were for her predecessors, who spent a ​combined 120 billion pounds ($160 billion) ⁠to shield households from job losses caused by COVID and the surge in energy prices after the invasion of Ukraine.

Public debt was an already historically high 83% of economic output shortly before the pandemic and stands at 93% now.

Reeves this week said any help for consumers would be targeted at “those who need it most”, mindful of the worries among investors about the cost of another huge bailout.

Analysts at Capital Economics said baseline tax cuts and one-off payments that Reeves ⁠might offer could ​amount to 24 billion pounds, or less than half of the support in 2022 and 2023.

Millard said Reeves had room for manoeuvre ​to help some households, but it would need to be handled delicately to retain the confidence of bond markets.

“The key is she needs to make sure that the support she provides is targeted at those people that really need it,” Millard said. “She’s also got to ​also make sure that they don’t endanger their fiscal rule, because if they do, then the markets I think would react quite badly.”