This week could end up being the most consequential for the UK economy since the start of the Iran war. The US and Iran are scheduled to meet in Switzerland on Friday to sign a deal that would reopen the crucial Strait of Hormuz. Oil prices have already dropped sharply on expectations of a deal, which will help to limit damage to the economy and give the Bank of England another reason to keep interest rates on hold on Thursday.

Closer to home, the result of the Makerfield by-election on Thursday will most likely determine whether we have a new Prime Minister later this year. But changing Prime Minister won’t change the challenges facing the government. If Mr Burnham wants to spend more, he’ll have to raise taxes or convince markets to lend him more. Both options come with significant downsides.

Iran-US deal to mitigate worst of the economic damage

The announcement of a deal between the US and Iran, due to be signed on Friday, has sent oil prices plummeting to a little above $80 per barrel (pb). Of course, the deal hasn’t been signed yet and even if it is any peace will be fragile.

The drop in energy prices will mitigate the worst of the damage from the war. Most importantly, the deal would remove the risk of energy prices surging again over the summer as stocks become depleted, which would have pushed inflation much higher and tipped the economy into recession.

However, there is still a wave of inflation already built into supply chains that will continue to push up the prices of key goods like food and construction materials through the rest of the year. As a result, inflation will probably now peak closer to 3% than 4%, but that is still well up from the 2% we were expecting before the crisis.

Will the ‘King of the North’ move south?

Polls and betting markets give Andy Burnham a roughly 75% chance of winning the Makerfield by-election on June 18. If he wins, it’s very likely that he will go on to challenge Keir Starmer and become the UK’s next Prime Minister.

For the economy, this raises the risks associated with another messy leadership battle. The Labour Party would still have an incentive to install a new leader before its annual conference in late September. A leadership contest focused on tax rises or ideas for borrowing will likely sap business and consumer confidence and spook financial markets, dragging on growth in a similar way to the previous two budgets effectively stalled the economy.

However, given betting markets and pollsters expect Andy Burnham to win convincingly in a leadership fight, we do have to think about what a Burnham government would look like.

In recent comments Burnham has committed to sticking to the current fiscal rules. But he also has made it clear that he wants to spend more. We doubt he would make major changes to the fiscal rules for fear of spooking the bond market and being accused of a ‘Liz Truss 2.0’. However, the direction of travel is clear.

But that is easier said than done. The recent row over defence spending highlights the challenge. Abiding by the rules while also ramping up spending wouldn’t be easy. The tax burden is heading for a record high and any cuts in welfare or public services would likely face significant resistance from the Labour left.

Andy Burnham’s fiscal path: two potential roads

The first path is to raise taxes and spending roughly equally, meaning little change in borrowing and the current fiscal rules. That would keep the bond market happy, but looks difficult to do whilst sticking to the manifesto commitments not to raise income tax, national insurance or VAT. This raises the risk of more wealth taxes, which tend to be difficult to implement and raise much less than advertised.

The second is to loosen policy and borrow more, either by changing the fiscal rules or by borrowing more now and pencilling in bigger cuts later on. However, it will be difficult to sell more backloading of taxes to markets, given the current fiscal plans are already heavily backloaded. Gilt markets are already highly sensitive to any signs of more borrowing. What’s more, more spending now would risk stoking inflation and prompting the Bank of England to raise interest rates.

The most likely result is a bit of both. That means more taxes and borrowing, and probably higher gilt yields over the next couple of years.

However, we don’t rule out Mr Burnham doing something more dramatic. Afterall, labour are well down in the polls and he will only have two years or so to change that. Given big investment projects, like building lots more social housing, take years to bear fruit, he may feel he has to do something big and quickly to have a chance at winning the next election.

Ultimately, though, any big plans will have to pass the bond market test. That means the most likely outcome is another round of tax and spend with a little more borrowing.

Inflation is likely to rise from 2.8% to 3% in May due to three key factors: airfares, motor fuel and vehicle excise duty.

Airfares year-on-year (y/y) are set to rocket from -13.2% to 1.2%, adding 7 basis points (bps) to inflation. Airfares are volatile with the timing of the easter holidays making a big difference to prices. The big picture is that airfares will continue to trend throughout the year as higher jet fuel prices make their way through supply chains.

Elsewhere, motor fuel inflation will rise from 23% to 24.8% y/y. That said, this is driven by a base effect as fuel prices nudged higher on the month, but were falling last May, putting upwards pressure on inflation.

Finally, due to the ONS overstating the rise in vehicle excise duty (VED) last April, it had to correct in May with an 8.7% drop, which will mechanically add 10bps to CPI inflation in May compared to April.

All told, inflation will rise in May, but around half of the rise will reflect the ONS’ correcting for last year’s error in the calculation. Further ahead, inflation will hold at similar levels in June before jumping to 3.5% in July as the Ofgem price cap is reset higher.

Thursday’s labour market data will show a continued weakness through April and May.

We expect the unemployment rate to increase slightly to 5.1%. There are two reasons for this. First, higher uncertainty due to the war in Iran, as well as higher energy costs will drag on consumer spending and squeeze margins, prompting a slowdown in hiring.

Admittedly, our forecast is close to rounding down to 5.0% and will depend on how much of the erratic jump in the single-month figures last month unwinds. In any case, we expect the labour market to weaken further in the coming months, with the unemployment rate peaking at 5.4% later this year.

As a result, the weaker jobs market will drag private sector regular pay growth, the measure most relevant to the Monetary Policy Committee (MPC) because it’s more reflective of underlying pay pressures, down from 3.0% to 2.9%. With pay growth being at or below the MPC’s estimate for target consistent pay growth (3.25%) for three months the labour market is weak enough to bring domestically generated inflation back to target despite the Iran crisis. That said, we think pay growth is likely to rebound slightly through this year as the official data is now below almost every private sector survey, which are consistent with pay growth settling at 3.25-3.5%.

The weak labour is one key reason we think the MPC will be on hold this week, and probably throughout the rest of this year as they balance a weak jobs market with rising inflation.

The Bank of England will almost certainly hold rates at 3.75% on Thursday in a 7-2 vote split.

Oil prices have fallen back a little since the MPC’s last meeting, amid hopes of a deal on Iran and signs of demand destruction in Asia. If oil prices hold at these levels then there will be little need for the Bank to respond by hiking rates.

However, the split on the Committee growing. We think two members will vote for a rate hike next week given that the Strait of Hormuz remains closed and some surveys point to sharply accelerating underlying price pressures. That said, we think the weaker labour market will keep the majority of the Committee too worried about worsening the jobs market to opt for a rate hike, unless energy prices go much higher.

Ultimately, there is still too much uncertainty for the Bank to gauge whether second-round effects are likely so will instead remain on hold in June. Further ahead, we think a weakening labour market and deteriorating economic outlook will keep the Bank on hold this year before cutting three times in 2027. But the risks are clearly weighted to at least one rate hike in the summer.

We expect retail sales to improve slightly in May.

The signals from BRC retail sales and Barclays consumer spending report were strong in May, but are unadjusted for the impact of the early Easter, so are likely a less helpful guide than usual.

In any case, last month was the third-warmest May on record and rainfall was below average so we think the better weather likely encouraged consumers to get out and spend. What’s more, retail sales continue to be steered by confidence among younger consumers which actually rose slightly in May as our chart below shows.

Elsewhere, fuel sales will likely jump slightly as they are now below pre-Iran war levels following last month’s 10.2% collapse, so we expect activity to normalise going forward.

Ultimately, we expect retail sales to nudge up by around 0.5% in May, but momentum will be subdued for the rest of the year as higher inflation drags on real incomes, prompting consumers to hold back on spending.

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