A severe but plausible scenario, in which a deterioration in the
Middle East conflict sustains some of the worst hits to the UK
economy so far, could result in a £16 billion borrowing hit –
massively reducing the Chancellor's headroom against her fiscal
rules, according to new Resolution Foundation research published
today (Wednesday).
With the conflict in the Middle East already dealing a domestic
blow to living standards – petrol prices are up 20 per cent,
diesel is up 36 per cent, and energy bills have been forecast to
rise by up to 20 per cent in July – the research examines its
wider economic impact on growth and the public finances.
The Foundation notes that the domestic economic fallout from the
conflict in the Middle East has so far been far more muted
compared to Russia's invasion of Ukraine. Back in 2022, gas
prices rose 300p per therm post-invasion, compared to a peak rise
of 78p in March 2026.
However, the UK does appear to be more vulnerable than most when
it comes to how the conflict is affecting its economy. Despite UK
GDP being half as energy-intensive as the world average, both the
IMF and OECD have downgraded UK growth by 0.5 percentage points
this year – the biggest markdowns for any G7 economy.
This is likely because of Britain's exposure to gas – which
accounts for 62 per cent of household energy consumption, more
than any other G7 economy – and the heightened sensitivity of UK
interest rates to global news. It notes that, for a typical
recent first-time buyer reaching the end of their fix, monthly
mortgage costs have increased by around £100 since the start of
the war.
While the future direction of the war is unknowable, a further
deterioration in the conflict could deal a significant blow to
growth and the public finances. To illustrate this the report
models a severe but plausible scenario in which some of the
largest falls in assets prices seen since the start of the war –
including a 9 per cent fall in equities and a roughly 0.5
percentage point increases in interest rates – are sustained, and
UK GDP is 0.9 per cent lower in three years' time.
Under this scenario, borrowing would be around £16 billion a year
higher in 2029-30, wiping out nearly three-quarters of the
headroom the Chancellor built up in her last Budget. Crucially,
though, her fiscal rules would still be intact even in this
severe scenario thanks to that additional headroom.
The Foundation says that with such a backdrop the Chancellor
should ensure any support with energy bills is targeted and
temporary. Providing unfunded universal support risks pushing
interest rates higher. For example, borrowing £20 billion to
provide additional support for households would be expected to
push up mortgage rates by a further 0.4 percentage points.
When it comes to the monetary policy response to the current
energy price shock, the report argues the economy may leave the
Bank of England scope to avoid needing to overreact. While it is
right to worry about a repeat of the wage-price spiral seen in
the wake of Russian's invasion of Ukraine, the economic climate
today is very different.
The labour market is in a weaker state today than it was back
then – unemployment is currently 4.9 per cent, compared to 3.8
per cent back in March 2022. Workers are therefore unlikely to be
able to secure big pay rises in the face of rising inflation and
could instead face painful real wage cuts. This should give the
Bank pause for thought when it considers whether to raise
interest rates in response to a temporary rise in inflation, says
the Foundation.
Simon Pittaway, Senior Economist at the Resolution
Foundation, said:
“No-one knows which direction the current conflict in the Middle
East will take, but we do know that it will make us all poorer.
The cost of filling up the car has already increased, and from
July, so too will energy bills.
“The conflict is going to make the state poorer too. A
deterioration in the conflict that sustains some of the worst
hits to the economy could deal a £16 billion hit to the public
finances.
“The Chancellor deserves credit for building up enough of a
buffer in last year's Budget to withstand a hit of this scale.
And by keeping any support with energy bills targeted and
temporary, she should be able to weather this latest economic
shock with her fiscal rules intact.”
