The National Institute of Economic and Social Research (Niesr) has revised its growth projections for the UK economy downward, signalling troubling economic headwinds as global conflicts, particularly the Iran war, exert pressure on financial stability. The think tank now anticipates growth rates of only 0.9% for 2026, a reduction of 0.5 percentage points from previous estimates, and 1% for 2027, down by 0.3 percentage points. With potential repercussions including a £35 billion economic hit and increased risk of recession, the outlook remains precarious for the government led by Keir Starmer.
Economic Fallout from Conflict
In a stark assessment released on Tuesday, Niesr highlighted the vulnerability of the UK economy to external shocks, particularly in the energy sector. As the conflict in the Middle East escalates, households are expected to face surging energy costs, prompting Chancellor Rachel Reeves to indicate that “nothing is off the table” regarding government support measures. Such interventions, however, come at a crucial time when the government is grappling with a significant fiscal gap exacerbated by rising inflationary pressures.
David Aikman, director of Niesr, emphasised the severity of the situation, stating, “This is a serious blow to the government’s mission to get the UK economy growing again.” He noted that even if hostilities in the region were to cease promptly, the lingering effects of higher energy prices would diminish household purchasing power, inflate business costs, and ultimately contract the economy beyond previous expectations.
Revised Growth Projections and Inflation Risks
Niesr has not only adjusted its growth forecasts but has also warned of a possible inflation shock should global oil prices escalate to $140 a barrel. Currently, Brent crude is trading at approximately $111. This scenario could push UK inflation rates above 5%, compelling the Bank of England to implement its most significant interest rate hike since Black Wednesday in 1992, potentially increasing rates by 1.5%.
Under a more moderate, yet still concerning scenario where energy prices gradually cool, Niesr predicts that the Bank will likely raise rates by a quarter point in July to 4%. However, some analysts suggest that there remains a possibility for an immediate rate increase during the Bank’s next policy meeting. Financial markets are currently anticipating the Bank to maintain its existing rate of 3.75%, with a minor chance of a quarter-point rise.
Implications for Public Finances and Political Landscape
As the economic ramifications of the Iran conflict unfold, the situation poses a significant challenge for the Labour government, particularly as local elections approach. Niesr estimates that the economic fallout could add nearly £24 billion to government borrowing by the end of the decade, substantially undermining Chancellor Reeves’s ability to adhere to her fiscal rules.
Stephen Millard, Niesr’s deputy director, pointed out the precarious assumptions made by financial markets regarding oil prices, suggesting that the projected decrease to $65 per barrel over the next two years appears overly optimistic. He warned that the Bank of England’s monetary policy committee will need to act decisively this year, insisting that Reeves will face difficult decisions ahead.
With rising borrowing costs, the yield on 10-year UK government bonds has surpassed 5%, while 30-year yields are approaching levels not seen since 1998. This uptick signals increasing concerns among investors about the UK’s fiscal health.
In response to the mounting economic pressure, Reeves has stressed the importance of targeted support measures rather than blanket policies, which she argues could exacerbate inflation. She noted the adverse long-term implications of the previous government’s untargeted support, which cost over £100 billion and contributed to rising interest rates and inflation.
Why it Matters
The downward revision of growth forecasts by Niesr underscores the precarious state of the UK economy, revealing the significant risks posed by global events such as the Iran war. With households and businesses facing heightened costs, the potential for recession looms large, challenging the government’s fiscal strategies and political stability. As the economic landscape continues to evolve, the ability of the government to navigate these turbulent waters will be critical not only for economic recovery but also for maintaining public confidence in its leadership.
