International politics was always likely to be a hazard for the UK economy this year. The deepening crisis in Iran and the Middle East over the past ten days reflects exactly this risk. For now, it’s impossible to tell how this latest escalation will play out. The only certainties so far are that the human cost in the region is already significant and the consequences will be long lasting.

It means there’s little point in making a firm set of forecasts for how the conflict will impact the UK economy and businesses. Instead, there’s a range of scenarios for how things might evolve. The first assumes the conflict is resolved in the next couple of weeks, meaning energy prices fall back swiftly, minor economic damage and rate cuts are delayed rather than cancelled. A second assumes energy prices stay around these levels for the rest of the year, which will probably mark a return to stagflation. The third is based on prices rising by a similar amount to when Russia invaded Ukraine. That would almost certainly mean a recession.

What higher oil prices mean for the UK economy

First, why is Iran so important to the UK economic outlook? The primary way events in Iran impact the UK economy is through energy prices. Around 20% of the world’s oil supply passes through the Strait of Hormuz. This is a narrow shipping route on Iran’s southern coast that connects the Persian Gulf to global markets. The region is also a major producer of liquified natural gas (LNG). Iran’s maritime neighbour, Qatar, produces 25% of global LNG. Shipping through the Strait has practically ceased, dramatically curbing energy exports from the region.

So, even though the UK imports relatively little energy directly from Iran, we do import about half of our energy needs from the region, especially in the form of LNG, which our electricity prices are heavily also based on. Since oil and gas are globally priced commodities, any disruption to supply from the region can push prices higher everywhere. That exposure to imported energy prices − especially natural gas − means higher energy costs quickly feed into UK petrol station forecourts, electricity and heating bills, raising inflation and squeezing household incomes.

Ultimately, the impact on the UK and Europe will depend on how high energy prices go and how long they stay elevated for, which leads to three broad scenarios.

Best case: rapid energy price stabilisation

In this benign scenario, the conflict ends in the next few weeks, energy exports from the region restart by the end of this month and energy prices quickly return to their pre-conflict levels of around $70 per barrel (pb) for oil and 77p per therm for gas. That would be down from the highs so far seen of around $110pb and 140p per therm.

Under this scenario, our economic forecasts would only be modestly changed. For fuel prices, petrol would briefly spike to around £1.50 per litre from last week's £1.32 average before falling back and, crucially, household bills would rise only by about 4% when the energy price cap is reset in July. That would probably mean inflation would average 0.1ppt higher this year and would probably knock just 0.1ppt off growth. It would also mean that interest rate cuts are delayed rather than cancelled. Here, the Bank of England (BoE) would keep rates on hold in March, but would probably cut in April and once more in the summer as the focus stayed on a weak labour market rather than rising inflation.

What higher energy prices for longer would mean

In the muddling through scenario, energy prices would stay around today’s levels for the rest of 2026. In this case, the energy price cap probably increases by close to 10% in July. That would add about 1.2ppts to inflation this year, meaning that rather than falling back to 2% and ending the year between 2% and 2.5%, inflation never reaches 2% and quickly climbs back above 3%. This would probably knock about 0.5ppts off GDP growth forecasts this year, reducing it to 0.5−1%. That would be similar to the stagflation environment of recent years and poses a dilemma for the BoE.

Normally, we’d expect the BoE to ‘look through’, or ignore, a one-off energy price shock. That’s because its impact on inflation would only last for a year, while it takes two−three years for interest rate changes to fully impact the economy. Instead, the BoE would usually focus on the negative impact on demand. However, inflation has been above the 2% target now for almost five years and inflation expectations are still above normal levels. That means the BoE may not feel it has the luxury of looking through another energy price shock. That probably rules out any further interest rate cuts this year, but it doesn’t necessarily mean interest rate hikes either.

In the ‘bad’ scenario, the Strait of Hormuz remains off limits for a prolonged period and energy exports from the region stay sharply curtailed. Energy prices rise sharply with oil over $110pb and natural gas at 240p/therm. Fuel prices rise to £1.60 per litre and the energy price cap rises by around 80% in July. This would push inflation up towards 5% and push the UK economy into recession. In this case, we suspect the BoE would still choose to keep interest rates on hold rather than raise them immediately.

The looser labour market means the economy is much less likely to experience a prolonged surge in inflation due to second-round effects − where firms and households respond to the shock by pushing for higher wages and passing higher costs on − like it did after the Russian invasion of Ukraine. However, the BoE may decide it would need to increase interest rates to rebuild its credibility and prevent any second-round effects, which would worsen a recession. This is probably the only scenario where the government feels under pressure to provide some sort of support to offset the hit to real household incomes and businesses.

It’s obviously too early to tell which of these scenarios is more likely. But, going into this crisis the business environment is arguably tougher than now than it was in 2022. Interest rates and taxes are higher, insolvencies have already risen sharply since then and the labour market is weaker. That will make it harder for businesses to pass on costs. While that does reduce the risk of an inflation spiral, it would raise the risk of businesses having to absorb even more costs, which makes a recession all the more likely if energy prices continue to rise.

GDP likely continued to recover in January

When the data's published on Friday, we expect GDP to have grown 0.2% in January as the UK economy rebuilds from its weak end to 2025.

On the production side of the economy, we anticipate the figures to show just 0.1% growth here. That’s because surging utility supplies are likely to be outweighed by another big drop in North Sea Oil loadings.

Meanwhile, the malaise in the construction sector is unlikely to end any time soon. We expect output to fall by another 0.5% m/m, the same as in December. The PMI did improve in January, but it remains well below 50. Add in wet weather in the first few months of the year and construction output is set to be a drag on growth throughout Q1. Admittedly, while construction output has fallen sharply for three consecutive months, brick deliveries did improve in January. So, there’s a chance of a brief bounce before another drop in February. In any case, we see no sign of genuine recovery in construction just yet.

As always, services output will be the big determinant of growth in January. We see it rising by 0.2%. January’s surging retail sales will directly add almost a full 0.1ppts to growth for a start. The services PMI rose to 54.0 in January, the highest since August, which suggests growth will be broad based in private sector output. The icing on the cake will be surging health output as the drag from the resident doctors’ strikes in December unwinds and A&E appointments rise. Indeed, the combination of these three factors means we see an upside risk to services sector output in January.

All told, January’s GDP figures will show the economy continuing to come back to life. That probably continued into February, but the big question now is to what extent will uncertainty and higher energy prices from conflict in Iran and the Middle East will weigh on activity in March and throughout the rest of the year.

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