We’re now into the fourth week of the Iran conflict, but there were two significant developments last week. First, Iran began targeting regional energy infrastructure in response to attacks on its own energy facilities. This matters more to markets than the previous strikes because damage to energy plants could take years to repair. It means that even if there is swift end to the crisis, then energy supplies from the region would remain disrupted and prices higher for longer. Second, even though the US Federal Reserve, the European Central Bank and the Bank of England all held interest rates last week, central bankers made it clear that interest rate rises weren’t just a theoretical possibility and there’s a real chance that rates would have to rise. That sent financial markets tumbling.

Why rising energy costs will hit some sectors more

The good news is that natural gas and electricity prices are still well below the highs from the last energy crisis, which points to only a modest rise in firms’ energy costs. But, if the chances of a swift resolution look to be diminishing, which industries will be hit the hardest?

It shouldn’t be surprising that the most energy-intensive industries are transport, agriculture and manufacturing. These industries are heavy users of fuel and electricity and aren’t protected by the Ofgem price caps that help households. Most firms are now on fixed energy-price contracts, so the impact may feed through only gradually. However, spot electricity prices have risen by about 50% since the escalations started. The previous energy crisis suggests that manufacturers of basic metals, glass, textiles and basic chemicals are at greatest risk. Indeed, back in 2022 the manufacture of paper, cements, glass and chemicals dropped by a third and metal production dropped by almost half. In total, energy-intensive manufacturing dropped by a third, compared to a 6% drop in other manufacturing and a 16% rise in services.

So, service industries in general look less exposed. But, not all service industries are equal. The most energy-intensive sectors of the services industries are hospitality and retail given their large heating and lighting costs. What’s more, rising energy prices are a drag on households’ disposable incomes. The rise in fuel prices alone so far will add about £170m a week onto households' and firms’ fuel costs. Combine that with the inevitable hit to consumer confidence and spending is likely to slow. Indeed, food and drink service businesses were more likely than any other industry in November 2022 to say they planned to cut trading by at least two days per week to reduce energy costs. This makes sense because it could take just a small rise in costs or a drop in demand to make opening on certain days unprofitable, especially when combined with higher wage and tax bills.

Could UK government support help firms and households?

Obviously, the situation is incredibly uncertain. But, the longer the crisis goes on for, then the bigger the impact will be, even if energy prices stabilise around current levels.

On the costs side, higher oil prices flow through to fuel prices with a lag of a matter of weeks. Yet, consumers’ utility bills won’t rise until July and will also feed through gradually for businesses as contracts reset. Higher gilt yields and the rise in interest rate expectations will also feed through into higher borrowing costs.

On the demand side, through a temporary price rise consumers are more likely to temporarily reduce saving to keep spending plans the same. But, the longer prices remain high, the more likely they are to reduce spending. At the same time, mortgage rates have reset substantially higher. The impact of that will increase the longer energy prices stay high. The result is that there probably hasn’t been much of an impact on spending yet, but the impact will get much larger by the end of the year if energy prices stay elevated.

The government will also struggle to offer the same kind of support it did in 2022 and 2023 given the tough fiscal outlook and sharp rise in gilt yields. Plus, any government support would make the chance of an interest rate hike substantially higher, offsetting its benefit.

The likely drop in demand combined with the already-weak labour market will make it harder for firms to pass on cost increases as they did in 2022. It makes it more likely that firms will have to reduce output to cut costs, which could further weaken demand and the labour market. That makes another inflationary surge less likely, but it does increase the risk of recession. Ultimately, everything hinges on what happens in the Middle East.

Wednesday’s release of the official data will likely show inflation held steady at 3% in February.

Services inflation should drop back to 4.1% from 4.4% off the back of lower hospitality inflation. Firms likely hiked prices by less in Feb 2026 than in Feb 2025, which is when firms started to increase prices in response to higher employer taxes introduced in the 2024 Autumn Budget.

Motor fuels inflation will also drop sharply, but February’s inflation data will feel redundant as pump prices have already started surging in March due to the conflict in Iran. Indeed, February will feel like a long time ago now.

We expect inflation to rise in March as the initial impact of higher fuel prices begins to show up in the official data. As pump prices rise to around £1.60 per litre by April, we expect inflation to fall only a little, compared to slowing to 2% as previously forecast. Further ahead, the rise in natural gas prices will see Ofgem increase the energy price cap in July, exerting further upwards pressure on inflation and taking it back over 3%.

All signs point to retail sales dipping in February after January’s stellar month that saw sales surge 1.8% m/m.

Retail sales are volatile so some of January’s big rise is unlikely to unwind in February, which will drag on sales. However, beyond the statistical quirks, there’s good reason to think retail sales will be weak. Consumer confidence dropped three points to -19, and the Major Purchasing Intentions index, which is the best indicator of consumers’ willingness to spend, dropped by four points to -14. This will be compounded by heavy rainfall that kept shoppers away from the high street. The UK had 23% more rain than in a typical February and for England that figure was even higher.

Alternative measures of retail sales were also weak in February. Barclay’s consumer spend report showed retail spending growth slowed to 1.3% y/y from 1.7% y/y in January. The signal from the BRC measure was even weaker. All told, we expect retail sales to dip in February. Confidence will likely worsen in March in response to rising fuel prices, which will drag on disposable incomes and dampen the outlook for retail sales this year.

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