Iran War Fuels UK Inflation, Slows Growth, NIESR Warns

The ongoing conflict in Iran is anticipated to maintain high oil prices and inflation within the United Kingdom, posing significant financial challenges for the government. Analysts at the National Institute of Economic and Social Research (NIESR) have warned of "very difficult trade-offs" in the upcoming autumn budget if these price pressures persist.

Inflationary Pressures and Economic Slowdown

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With oil prices briefly exceeding $100 a barrel and the Strait of Hormuz facing disruptions since March, the NIESR predicts inflation will climb to 3.8% over the next seven months. This surge is expected to impact the chancellor's budget, potentially requiring an additional £24bn by the end of the decade to sustain public services and real-terms welfare payments. The thinktank has revised its forecast for the chancellor's spending headroom downwards, from over £7bn to closer to £3bn. The Office for Budget Responsibility had previously estimated around £22bn in spare capacity.

The NIESR also projects a slower pace of economic growth for the UK this year and in 2027. Higher energy prices and the wider uncertainty stemming from the conflict are cited as key reasons. This downgrade means the UK could experience £28bn in lost growth over two years compared to earlier projections made in January. The institute's director, David Aikman, described the situation as a "challenging inheritance" for the new prime minister, with spending eroded by inflation, high borrowing costs, and new demands on public funds.

Debt Levels and Funding Strategies

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The NIESR highlighted that the UK's total national debt has reached nearly £3tn, equivalent to 95% of the annual national income. The institute cautioned against using increased borrowing to fund new initiatives or public spending, stating it would be a mistake that could lead to future difficulties. Instead, new commitments, whether for defence or household support, should be financed through taxation or savings elsewhere. Rebuilding the nation's capacity to withstand future shocks requires a dedicated effort to reduce debt.

Stephen Millard, head of macroeconomic forecasting at NIESR, noted that while the UK economy had shown resilience in the first half of the year, a slowdown is still anticipated. He indicated that even with a relatively swift resolution in the Middle East, inflation would persist, necessitating difficult decisions regarding funding for policy announcements such as VAT cuts on electricity or business rates reductions for pubs. Millard suggested prioritising tax changes over increasing existing tax levels, advocating for measures like a land value tax and phasing out VAT exemptions.

Future Outlook and Policy Implications

The NIESR's latest economic outlook indicates that the chancellor will need to manage a real spending squeeze of approximately 4% by the end of the decade, translating to about £24bn in 2023 prices. The thinktank expects inflation to average 3.1% in 2026, peaking at 3.8% in February 2027, with a return to the Bank of England's 2% target not anticipated until early 2029. Financial markets are currently expecting the Bank of England to maintain interest rates before potentially raising them to 4% later in the year.