The week ahead: new conflict in Middle East raises inflation risk

Escalating military tensions in the Middle East are heightening geopolitical pressures at a time when tariff concerns seemed to be subsiding.

The primary way this will impact UK businesses and the economy is through higher oil and natural gas prices. Indeed, oil prices have risen by about $10 per barrel (pb) in the last week, reaching $75pb on Friday. To put this into context, this time last year oil prices were around $85pb and they are still way off their 2022 peak of over $120pb.

The most immediate impact will be on prices at the pump. A $10pb rise in oil prices will probably result in a 5p increase in pump prices over the next couple of months. As higher fuel prices make their way through the system, a rule of thumb is that a $10pb rise in the price of a barrel of oil eventually adds 0.1% to 0.2% to inflation. Natural gas prices have also risen, but by a slightly smaller amount.

If oil prices stay around these levels, then it’s unlikely to make much difference to the Bank of England (BoE) and the paths for interest rates and economic growth this year. But that’s a big if.

Iran accounts for about 3% of global oil supplies. What’s more, about 20% of global oil and liquified natural gas (LNG) flows through the strategically important Strait of Hormuz. So far, no energy facilities have been targeted or supplies disrupted, which means the fundamentals of the energy markets haven’t changed. Indeed, the oil market is still over supplied due to increased production from OPEC+ nations and a slowdown in global growth.

But what the surge in oil prices and the lesser rise in natural gas prices does represent is an increase in risk premium.

The big danger is an escalation that disrupts energy supplies from the region. This would send energy prices much higher. In that case, a rerun of the 2022 energy crisis would be possible, with higher interest rates and another bout of stagnation or even recession. That would throw all of Rachel Reeves’s spending plans out of the window.

Tax rises more likely after the Spending Review

After last Wednesday’s announcement, we now have a clear picture of where the government intends to spend money over the rest of the parliament. That said, elements of the Autumn Budget that weren’t in the Spending Review will prove to be much more important for future tax rises than anything announced last week.

As expected, the big winners were health, education and defence with transport and the Foreign Office the big losers.

On the question of whether the chancellor’s plan overall will be a winner, the answer depends on what happens around three big risks.

First, the spending plans will remain difficult to stick to. Once we net-off health, education and defence, day-to-day spending in the rest of government looks tight; especially with no rainy-day fund for creaking public services, rising demand and the pay disputes that are bubbling up again.

Second, defence spending may have to rise more rapidly. Increasing the defence budget to 3% of GDP this parliament instead of next would cost an additional £15bn.

Third, any downgrades to the Office for Budget Responsibility’s (OBR) forecasts could cost the chancellor dearly. The OBR remains very optimistic on productivity growth. However, if it brought its forecasts closer in line with recent productivity growth rates, then it would leave a £30bn hole in the forecasts.

Given that much of the increase in capital spending over the next five years is going on defence and net zero, which don’t necessarily generate ongoing productivity gains, the OBR may decide now is the time to change its view.

Are tax rises in the autumn inevitable?

Even if these three risks don't materialise, then tax rises are still probably on the way in the autumn.

The combination of U-turns on welfare spending, higher interest rates and slower growth has probably used up the £10bn headroom Reeves clawed back in March. Indeed, welfare and debt interest combined are forecast to rise by £65bn over the next three years.

This is about half of the forecast total increase in spending. It means that small changes in these categories, which the government has much less control over than spending in other areas of government, can have a big impact on how much fiscal headroom the chancellor has in the autumn.

The weak GDP and labour market data from last week won’t have helped the budget maths either. There was more evidence that the big jump in employment costs introduced in April is having a chilling effect on the labour market with the number of people on payrolls in May falling by 109,000. This is the biggest fall in two years. What’s more, the economy made a poor start to Q2 with GDP contracting by 0.3% in April.

Admittedly, we are not overly worried by either data point. The first estimate of payrolls is notoriously unreliable and will almost certainly be revised up. Other labour market indicators suggest that employment growth is weak, but not collapsing.

Meanwhile, just as the 0.7% growth for Q1 overstated the strength in the economy at the start of the year, the drop in April is overstating the weakness. Looking through the volatility, underlying growth is still positive. But, these data points highlight just how vulnerable the chancellor is to an economic downgrade due to the tiny amount of fiscal headroom she left herself in the Autumn Budget.

That said, we don’t think the chancellor will need to raise nearly as much this time round. A top up of £10–20bn seems more likely, which could probably be accomplished through a combination fiscal drag, increasing fuel duty and stealth taxes. If she needs to raise more significant amounts, then pension reform seems the last option without breaching the manifesto commitments.

However, the things that really matter for the next budget are now largely out of the chancellor’s control. Reeves will likely have to endure a cruel summer of endless speculation about which taxes will increase and by how much.

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