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Sir Keir Starmer pledged on Friday to build Britain’s economic resilience in the wake of a conflict “that is going to define us for a generation”.
Investors were not reassured: even as the prime minister spoke, an earlier rally in gilts was petering out, underlining their assessment that the UK economy is among those most exposed to the Iran war energy shock.
The country has not only suffered from greater market volatility than others since the war started. It also received the biggest downgrade of any advanced economy when the Paris-based OECD updated global forecasts last month, warning that growth in GDP would slow sharply this year and inflation would accelerate to 4 per cent.
Economists said this reflected the UK’s weak economic backdrop at the onset of the shock, a lack of space for new monetary or fiscal stimulus, structural over-reliance on imported gas and lingering worries over political stability.
Britain began the crisis with higher inflation and slower growth
Stefano Scarpetta, OECD chief economist, said the UK stood out before the Iran war for its unusually weak outlook, even as peer countries began to feel a boost from the rollout of AI.
“Before February 28 we were set to revise up [growth forecasts] for most countries . . . not for the UK,” he said, pointing to stalling growth in the services sector at the end of 2025, a decline in construction, weaker business investment and slower household income growth.
Unemployment was also rising in the run-up to the war, while inflation was running at 3 per cent in February, even before the surge in oil prices hit consumers at the petrol pumps.
The UK has less policy space to respond to a stagflationary shock
The stagflationary shock is likely to widen divisions among members of the Bank of England’s Monetary Policy Committee over the risks that a temporary, energy-induced rise in inflation could turn into a long-term problem for the central bank if price pressures become entrenched.
Andrew Bailey, BoE governor, has pointed to the weak jobs market as a reason why a persistent inflation problem is less likely to develop now than in 2022 — when workers were better able to bid up wages and companies to pass their higher costs into prices.
But the cuts to interest rates — now at 3.75 per cent — previously expected to support growth later in the year now look unlikely to materialise.
James Smith, chief economist at the Resolution Foundation think-tank, said that even if the BoE did not need to “stamp on the brakes” by raising rates, the government’s tight fiscal position would make it difficult to lessen the squeeze on households through help with energy bills.
The UK is structurally more exposed to high oil and gas prices
Britain is especially vulnerable to gas price shocks because the fossil fuel still accounts for a bigger share of its energy mix than in other countries that have done more to electrify their economies or done less to move away from dirtier coal.
Because gas is generally the marginal source of supply, high gas prices also push up electricity prices across the board.
This will hit households hard later in the year, when regulated energy bills rise. It is already feeding through to business energy bills and affecting investment decisions — as seen in OpenAI’s decision this week to halt its plans for data centre expansion in the UK.
Gilt market volatility is already hitting the real economy
The dramatic swings seen in gilt markets are already feeding through to the real economy, as higher borrowing costs drive up mortgage costs and hit the housing market.
Survey evidence published this week by the Royal Institution of Chartered Surveyors, a professional body, showed enquiries from new buyers had slumped to their lowest level since 2023.
Andrew Goodwin, at the consultancy Oxford Economics, said high numbers of homeowners were set to renew fixed-term mortgage deals this year, with “unfortunate timing” and a “potentially significant impact on demand”.
Political instability makes restoring confidence an uphill battle
Economists are clear that the UK government is paying a premium to borrow because it has lost credibility with investors after years of slippage on fiscal promises.
“When yields fall globally, on those days the UK fares worse — it looks like there is extra stigma attached to UK government debt,” said Smith.
Maxime Darmet, senior economist at insurer Allianz, said worries over the credibility of the government’s fiscal plans had been amplified by the Iran war.
The conflict increased pressure on chancellor Rachel Reeves to spend more on defence and household support, while the Labour Party could soon opt for “a change of leadership less committed to fiscal discipline”, he added.
Even economists who were more upbeat about the UK’s economic prospects at the start of the year admitted that it would be hard now to restore consumer confidence and regain momentum.
“Only a few weeks ago people were saying, ‘Maybe this is the year growth will rebound’ . . . It seems like another shock has postponed that,” said Tom Smith, director of economics at the Tony Blair Institute think-tank. “Confidence is quite fickle . . . it tends to be easier to knock down than up.”
