The United Kingdom is confronting a potential £35 billion economic setback and the spectre of recession this year as the fallout from the Iran war intensifies pressure on Prime Minister Keir Starmer's administration, according to a leading think tank.
Niesr's Grim Forecast
The National Institute of Economic and Social Research (Niesr) has revised its growth projections downward, stating that even under the most favourable circumstances, the UK economy will expand at a significantly reduced rate this year and next due to the Middle East conflict. Niesr downgraded its 2026 growth forecast by 0.5 percentage points to 0.9%, and its 2027 forecast by 0.3 percentage points to 1%.
Energy Costs and Public Finances
With households facing increased energy costs linked to the Iran war, Chancellor Rachel Reeves has indicated that "nothing is off the table" as the government considers targeted, temporary support measures. However, Niesr warns that the government faces a multibillion-pound hole in public finances amid a worsening inflation shock, complicating Reeves' ability to respond.
David Aikman, Niesr director, stated: "This is a serious blow to the government's mission to get the UK economy growing again. The Middle East conflict has laid bare the fact that the UK remains highly exposed to global energy shocks. Even if hostilities ease rapidly, higher energy prices will leave households poorer, businesses facing higher costs, and the economy materially smaller than we expected only a few months ago."
Adverse Scenario and Recession Risk
Under an adverse scenario where global oil prices reach $140 per barrel, Niesr warns that Britain would face a much larger inflation shock than currently anticipated, potentially plunging the economy into a recession in the second half of this year. Brent crude oil was trading at $111 per barrel on Tuesday. Such a scenario could push UK inflation above 5%, forcing the Bank of England to raise interest rates by as much as 1.5% in a single move—the largest since Black Wednesday in 1992.
Even under the baseline scenario, which assumes a gradual cooling of global energy prices, Niesr expects the Bank to raise interest rates by a quarter point in July to 4%. However, it cautioned that a rise in borrowing costs at the next policy meeting on Thursday cannot be ruled out. Financial markets widely anticipate the Bank will keep rates unchanged at 3.75%.
Impact on Government Borrowing
With Labour facing pressure ahead of local elections next week, Niesr estimates that the economic hit from the Iran war could add nearly £24 billion to UK government borrowing by the end of the decade, almost entirely erasing Reeves' headroom against her self-imposed fiscal rules.
Stephen Millard, Niesr deputy director, remarked: "Things can be much worse. In a way, the assumption that oil prices have more or less peaked and will come down to $65 per barrel over the next two years looks to be increasingly optimistic. Either way, the Monetary Policy Committee will have to raise rates this year, and the chancellor will have some very tough calls."
Market Reactions
Amid speculation of a leadership challenge to Starmer after disappointing election results and the unfolding inflation shock, UK borrowing costs on global bond markets have risen sharply. The yield on 10-year UK government bonds rose above 5% on Tuesday, while the 30-year yield approached levels not seen since 1998.
Reeves told MPs in the Commons that her focus is on providing targeted support, as blanket measures would be costly and risk stoking further inflation. She criticised the previous government's untargeted support, which cost over £100 billion and led to higher interest rates, inflation, and taxes.
