UK Economic Outlook Clouded by Iran War as Forecasts Downgraded

Britain’s economy could face a “extremely significant” hit from the escalating conflict in Iran, the UK’s official forecaster warned on Tuesday, as the crisis threatens to derail Chancellor Rachel Reeves’ promise to deliver “stability.” Against a backdrop of market turmoil, the Office for Budget Responsibility (OBR) downgraded Britain’s growth forecast to 1.1% in 2026, acknowledging the projections are subject to considerable uncertainty.

Growth Forecasts and Inflation

Rachel Reeves presented the new economic forecasts to MPs, but the figures were prepared before the recent escalation of conflict in the Middle East, which triggered a surge in energy prices and rattled global markets. The OBR expects slower growth this year but upgraded its forecasts for 2027 and 2028 to 1.6% from 1.5% previously.

Reeves stated that the OBR projected inflation to fall faster than expected in the autumn. She also highlighted that the “headroom” against her fiscal rules, which stood at £21.7 billion following November’s Budget, had increased to £23.6 billion.

Market Reaction and Interest Rate Expectations

The presentation coincided with a sell-off in the gilt market, with the 10-year gilt yield rising 0.09 percentage points to 4.47% as rising energy prices prompted traders to scale back bets on interest rate cuts from the Bank of England (BoE). The probability of a quarter-point interest rate cut at the BoE’s meeting this month has fallen to approximately 25% from 90% on Friday, according to swaps contracts. Traders now anticipate just one cut by the end of the year, down from two reductions previously expected.

Government Borrowing and Fiscal Policy

Fund managers welcomed the government’s announcement that it would sell £252 billion of gilts in the year to March 2027, in line with investor expectations and down from £304 billion in the previous year. Though, the UK remains heavily exposed to surging gas prices, which threaten to impede the BoE’s efforts to return inflation to its 2% target.

Consumer price inflation was 3% in January. Higher energy prices immediately impact UK consumers through petrol pump prices; typically, each $10 per barrel rise in oil adds about 0.1 percentage point to CPI inflation within months, with a similar impact as higher costs pass down supply chains. Household energy bills react more slowly, meaning the rise in wholesale gas prices won’t be fully felt until July when regulator Ofgem next updates its energy price cap. The UK tends to be more affected by changes in gas prices than other European countries, as its electricity price is more frequently determined by gas prices.

Reeves’ Strategy and Labour’s Position

Reeves sought to project confidence and calm, telling MPs she had the “right” plan for the British economy and had brought order to the public finances. She repeatedly emphasized “stability,” but the events in the Gulf have put her strategy – based on hopes of falling inflation, lower interest rates, rising business confidence and improving living standards – at risk.

Reeves reinforced the public finances in her November Budget, providing a foundation for Britain to withstand the new turbulence. She cautioned against loosening fiscal discipline with higher borrowing and spending, warning against “easy answers and reckless borrowing.” She also issued a warning to her party not to destabilize the leadership of Keir Starmer.

Looking Ahead

Reeves announced she would hold talks with sectors most affected by the Iran war, including North Sea energy companies and the shipping industry. The OBR’s forecasts are subject to significant revision as the situation in the Middle East evolves, and the impact on the UK economy remains highly uncertain.