Soaring energy prices due to the Persian Gulf crisis are setting UK households up for a year of at least stagnant and possibly even falling real incomes. The spike in energy costs will add to the pressure on real incomes from a higher tax burden and the weaker labour market and risks another cost-of-living crisis. Admittedly, households do have room to reduce their saving rates to offset some of the impact on spending. However, it’s inevitable that spending growth will slow this year and could easily turn negative, prompting a recession if energy prices rise higher.

Could there be another cost-of-living crisis in 2026?

Even before the Iran crisis, we’d expected real household disposable income (RHDI) to only grow modestly this year at roughly 0.5%. This was because we thought inflation would rise back over 2.5%, while the higher tax burden and weaker labour market would weigh on nominal income growth.

Using three different scenarios for inflation, we can actually gauge the potential impact on household incomes of the surge in energy prices.

1. In the best-case scenario, energy prices fall back quickly, although remain elevated relative to pre-conflict levels due to the damage to energy infrastructure and shipping disruption.
2. In the middle scenario, energy prices stay at current levels for the rest of the year.
3. Meanwhile, in the worst-case scenario energy prices rise to $150 per barrel and gas prices reach 300p a therm and stay there until the end of the year.

Even the best-case scenario would be enough for real household incomes to all but stagnate this year. In the middle scenario, real household incomes experience a small fall of 0.3%. In our worst-case scenario, incomes would fall by around 2% this year, with most of that felt from July onwards. This is a similar level to how much RHDI fell by in 2022, even with government support.

Weak consumption doesn’t always follow weak income growth

Despite the depressed outlook for RHDI, it doesn’t have to mean that consumption will be equally as weak. After all, households are saving almost 10% of their income and could use some of this to smooth through the shock.

Indeed, during 2022 households slashed the proportion of income they were saving to a low of just 3.8% in Q2. Excluding pension contributions, the savings ratio turned negative in Q2 and Q3 2022 as households used their rainy-day funds to support consumption. Clearly, households can be willing to weather the hit to real disposable incomes. The big question is to what extent.

There are a few factors at play here. Households are much more likely to maintain their consumption plans by saving less if they think the shock will be brief. However, if the shock persists in the medium-term, then households would likely start cutting back on consumption, as well as reducing saving. In the 2022 shock, it wasn’t until 2023 when consumers started slashing their consumption.

Either way, households would want to rebuild their savings after such a shock, just as they have in the last few years after the previous energy crisis. This would imply weaker consumption growth into 2027, even if the crisis is resolved by then.

In any case, we assume households offset around half of the immediate hit to consumption through lower savings. This means that in our best-case scenario, the hit to consumption would likely be marginal as consumers briefly save a little less.

In the middle scenario, the savings ratio would need to drop to a little under 9% later this year to absorb half the hit to consumption. That suggests a smaller impact than in 2022 for the time being, while ensuring that consumption ticks along − just at a more subdued level. Assuming consumers adjust their saving habits in line with that assumption, then instead of rising by 0.5% this year, consumption would stagnate.

In our worst-case scenario, consumption the savings ratio would drop to around 7%, with consumption probably end up declining by around 0.5%. This would still see households saving around 3% of their incomes outside of their pensions

Will the UK government offer support for energy bills?

Another reason to think that the impact on consumption will be smaller is that the government may step in with a package to protect household incomes from higher energy bills. We’ve already seen some funding to help households with home heating oils.

That said, the government’s fiscal position remains precarious. Policymakers therefore may not be as generous as they were during the cost-of-living crisis where the IFS estimates the government spent £75bn supporting households and businesses with energy costs. This time, support is likely to be targeted and more modest. What’s more, looser fiscal policy would be more likely to prompt the Bank of England to raise interest rates, offsetting the positive impact on consumption.

Ultimately, higher energy prices will weigh on an already-weak outlook for real incomes this year. Alongside tighter financial conditions, which will reduce credit availability, this makes it inevitable that consumer spending will slow because of higher energy prices. Fortunately, households have plenty of room to cushion the blow to disposable incomes alongside any government support, which should offset some of the impact on growth. All told, weaker consumption means growth is likely to slow to around 0.5% this year. But, there is a risk of consumers cutting back on spending more aggressively than we anticipate, making recession a possibility. Even as consumers weather the storm, the desire to rebuild savings in the aftermath of such a shock means the rebound will likely be slow.

Related insights