We’ve been here before. The on-off, distinctly fragile ceasefire in the US and Israeli war with Iran has once again been sending oil prices shooting up, increasing the economic threats posed by the conflict, then sending them tumbling as the US suggests a resolution is close. A deal would immediately remove the risk of a significant energy crisis for the west amid depleting oil stockpiles, and that of soaring inflation – spectres that have been rattling markets, although not overly so.
Close to ending or not, the war has shone an uncomfortable spotlight on the UK economy. The confluence of the new risk of rate hikes and rising concern about the country’s economic management and political leadership has persuaded bond investors, in Britain at least, to jump off the fence, pushing 10-year and 30-year gilt yields to their highest levels in decades.
A government lurch to the left in the event of a local election bloodbath for Labour is viewed as a significant threat to economic stability, and while gilt yields are likely to fall in the event of a complete agreement between Iran and the US, the additional premium placed on UK borrowing relative to other G7 economies is unlikely to melt away. Even if Keir Starmer survives as prime minister, the political pressure to increase spending – funded through further borrowing and/or tax rises – will be immense.
An absence of rate hikes and the return of rate cuts matter enormously. Certainly, the longer-than-expected duration of the war has forced central banks to ponder how to manage worst-case inflation scenarios. Last week the Bank of England (BoE), which opted for an “active” hold on rates at its Monetary Policy Committee meeting on 29 April given the existing tight financial conditions, stressed it would be monitoring for signs that second-round inflation is beginning to take hold.
This is its chief concern; it cannot do anything to temper energy prices or their impact, but it expects second-round effects to materialise fairly quickly. Indeed S&P Global has warned that input cost inflation accelerated sharply last month and was the highest since November 2022. A worry for the BoE is the knock-on effect on wage negotiations for 2027. After the shocks of recent years, households will be highly sensitive to new emerging price growth risks.
In the BoE’s worst-case macro scenario (prolonged war and persistent high energy prices), as outlined at last week’s meeting, CPI inflation could hit 6 per cent (up from 3.3 per cent now) and Bank rate could potentially rise to 5.25 per cent. Its most benign scenario pictures a shortlived energy shock and no rate hikes. That would follow a US-Iran agreement.
Capital Economics’ adverse scenario has inflation rising to 7 per cent and rippling out across the economy, ending up in second-round effects over a period of two to three years as workers and firms bid up wages and prices to defend incomes and profits.
In HSBC’s own ‘bad scenario’ for energy prices, it argues that three rate hikes over the coming year (to 4.5 per cent) might be warranted.
If the US-Iran talks make progress, and the Strait of Hormuz reopens, the gloomy scenarios painted by the BoE and other commentators are highly unlikely to come to pass – indeed, a very different economic scenario lies ahead.
Nevertheless, even if the risk of rate hikes is dramatically reduced, and falling energy prices mean the chancellor ultimately avoids additional spending in the form of targeted support for energy bills to a swath of households, economists are struggling to look through the additional pressures of high-tax, high-spend policies and rising political risk in the UK.
Deutsche Bank’s assessment of how the Iran conflict has changed the outlook for the UK’s public finances concludes that government spending will rise and the chancellor’s already thin headroom of around £20bn in 2029-30 will fall to below £10bn. It expects to see big jumps in interest payments, a rise in welfare and defence spending, and “looser spending envelopes” in the next spending review. That’s in part because day-to-day spending this year is running at around 2.6 per cent but is pencilled in to rise by just 1 per cent in 2027 and 2028. It estimates that the next spending review will add at least £15bn to £20bn to borrowing and that “more efficiency savings [if even possible], spending cuts or tax rises will be needed to square the fiscal circle”.
Pantheon Macroeconomics agrees, noting that political pressure to deviate from the planned fiscal consolidation is likely to increase after the local elections, skewing the risks to a greater reduction in the chancellor’s fiscal headroom. The war may be drawing to a close, but Britain’s challenges are far from over.