The first draft of this note focused on last week's eleventh-hour ceasefire agreement, which briefly offered good news for the people affected by the conflict and the UK economy. It showed that even if the ceasefire were to hold, supply disruptions and elevated prices would persist. Since then, President Trump’s threat to blockade the Strait of Hormuz has highlighted how fragile any eventual ceasefire will be. Should the blockade materialise, energy shortages will worsen, pushing prices higher and increasing the risk of the UK falling back into stagflation − or even recession.

UK businesses impacted by soaring diesel prices

By cutting off the trickle of ships that had been transiting the Strait of Hormuz, most of which were Iranian or linked to Iran’s allies, President Trump hopes to ratchet up the pressure on Tehran by cutting off its main source of foreign income. However, a full blockade of the Strait will add further pressure to global oil markets. Oil prices surged by 7% this morning, putting them back above $100 per barrel (pb). Natural gas prices have also jumped by 8%.

The key risk to the global economy is that fuel shortages starting to emerge in Asia will start to be seen in the UK and Europe over the next few weeks and months as the last ships from the Gulf arrive at their destinations. This would push oil prices to unprecedented levels as importers compete for the remaining barrels available for shipment. Prices for physical barrels of oil, rather than 'futures' traded on financial markets, have already reached almost $150pb last week − a record high. If supplies remain disrupted, we'll soon see market prices chasing physical prices higher.

Ultimately, given the loss of roughly 10% of global oil supply, prices will have to rise high enough for ‘demand destruction’ − where high prices curb demand − to set in and rebalance markets. That’s why government efforts to reduce the cost of fuel, which would encourage demand, are misguided. The level at which demand destruction kicks in depends on the market. We’ve already seen jet fuel rationing and flight cancellations in Asia. There were also major fuel protests in Ireland at the weekend over the price of diesel. In the UK, diesel prices have now topped £2 a litre.

Diesel, jet fuel and heating oil prices have been especially impacted because more refining of these products happens in the Gulf and there aren’t strategic stores, like there are with crude oil. As a result, diesel prices have risen by roughly twice as much as petrol prices. This is especially bad for the UK. Almost 60% of UK fuel consumption is now diesel (it was 50:50 in 2006). However, since most diesel is used by businesses and most petrol is used by households, diesel has a lower weighting in the CPI basket. This means increases in diesel prices have a smaller impact on headline inflation than petrol prices. The diesel price surge represents a much bigger cost to businesses than will be implied by the increase in fuel inflation when figures are released next week.

Trumpflation means another lost year of UK growth

The good news is that the UK economy can cope with energy prices at current levels. Given inflation and energy efficiency improvements, oil prices of near $100pb aren’t nearly as damaging as they were even before the pandemic.

However, even if the ceasefire is reinstated, it’ll come too late to avoid another bout of stagflation. There’s three key reasons why.

First, energy prices at current levels are still enough to push inflation to over 3% by the end of the year. Once we add in indirect and second-round effects from supply-chain disruptions and shipping and raw material costs, it’s easy to forecast inflation of around 3.5−4% by the end of 2026. That’s significantly higher than the 2−2.5% we were expecting back in January. This is the ‘-flation’ part of stagflation.

Second, the fuel price surge has already eaten into consumers’ disposable incomes and businesses’ profit margins. For example, the UK consumes about 28.3bn litres of diesel and 18.6bn litres of petrol annually. So, even if prices don’t go any higher, we’ll still be spending an extra £16.5bn a year on fuel – that’s about 0.5% of GDP. The impact will get worse as higher wholesale prices are reflected in utility bills from July. This hit to consumer incomes will be further compounded if firms respond to the crisis by cutting employment or pay growth.

At the same time, the sharp upshift in interest-rate expectations and mortgage rates will further crimp consumer spending and business investment. Markets have gone from expecting two rate cuts this year, with a risk of a third, to pricing in a rate hike with the risk of a second. Indeed, the yield on 10-year gilts (the cost of government borrowing) has risen from 4.23% at the end of February to 4.86% now. That’s down from the 5% they reached in March, but still represents a huge increase in borrowing costs.

Admittedly, the Bank of England can probably hold fire on interest rate rises if it becomes clear that energy flows are resuming and prices should fall back. The Monetary Policy Committee (MPC) is more likely to look through the crisis if it can see sunlight on the other side of the storm. But, that outcome now looks increasingly unlikely. In any case, the 2−3 rate cuts that were priced into markets in February will probably have to wait until 2027 now.

Third, uncertainty will remain high for the foreseeable future. The latest news headlines will only increase uncertainty. Consumer confidence and business sentiment have dropped and will remain fragile until there’s a more permanent end to the conflict. If consumers delay major purchases and businesses defer deals and investment, then that will damage demand further.

This combination of lower disposable income, higher market interest rates and increased uncertainty means the economy will take a hit. That’s the ‘stag-’ part of stagflation.

Of course, the exact economic impact depends on what happens to energy flows and prices from here. But, lower growth and higher inflation is classic stagflation territory. If the ceasefire somehow holds and energy flows resume, then growth could be around 0.5ppts lower this year than we had previously thought. However, there is clearly now an even greater risk that prices surge. In that case, inflation will go much higher, demand destruction will kick in and households and businesses will reduce consumption, which means less economic activity. That will result in a recession. For now, another bout of stagflation is the base case, but the risks of a recession are clearly rising.

UK GDP: economy likely eked out some growth in February

We expect the economy to have grown 0.1% in February. This would be a small improvement from January's 0% .

Overall, February’s GDP report is likely to show the wet weather across much of the UK dragging on growth in many parts of the economy.

On the production side, mining output is likely to decline for a fourth consecutive month as winter storms disrupted North Sea loadings. That would offset a solid month for manufacturing, where we expect growth of 0.4%. This leaves industrial production falling by 0.1%.

Construction PMI fell again in February, while the Department for Business and Trade reported brick deliveries collapsed by 8.3%. This all suggests no near-term relief for builders.

The bright spot will come from the services sector. We expect growth to come in at 0.2% m/m. New car registrations rose strongly, which will help to offset February’s 0.4% drop in retail sales. Meanwhile, hospitality output should rebound to grow by 0.7% m/m after January’s collapse. That’s if the signal from the NIQ RSM Hospitality Business Tracker is right.

Overall, we expect growth to come in at 0.1% in February, with risks broadly balanced. The difficult weather conditions could hit mining and construction activity harder than we expect. Yet, growth undershot the steer from surveys in January. This may mean there’s some catch-up in February. Surging GP and A&E appointments may also mean health output rises by even more than the 0.3% we expect.

Further ahead, the UK economy is likely to slow in March. This is when uncertainty spiked and rising fuel prices started to eat into households’ disposable incomes. The economy will probably still squeeze out 0.2% growth in Q1, but any further expansion will likely slow into the second quarter of the year.

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