Britain’s small and medium-sized businesses are about to be marched back into the inflationary trenches they thought they had left behind.
According to fresh modelling from the National Institute of Economic and Social Research (Niesr), the war in Iran and the resulting blockade of the Strait of Hormuz will tear a £35 billion hole in UK output over the next two years, push consumer price inflation back above 4 per cent, and force the Bank of England to raise interest rates rather than cut them.
That is the optimistic reading. It assumes the fighting ends soon and that crude, currently trading near $110 a barrel, drifts back to $65 by the close of next year. Should the conflict drag on and oil spike to $140, a level last seen in the run-up to the 2008 crash, the damage doubles to £68 billion, and Threadneedle Street may be forced into the steepest emergency tightening since Black Wednesday in September 1992.
For the owner-managed firms that make up the bulk of the British economy, the implications are uncomfortably familiar. Energy bills are heading north again, household budgets will tighten just as confidence had begun to recover, and the cost of credit, already a millstone for growth-stage companies, is unlikely to ease before the autumn.
Niesr has cut its UK growth forecast for 2026 to 0.9 per cent, down from the 1.4 per cent it pencilled in as recently as February. The early-year momentum was real enough, gross domestic product expanded by 0.5 per cent in the three months to February and is on course for a respectable 1 per cent in the first half. The trouble starts in the second. As fuel and energy costs feed through into household bills, consumer spending power will be eroded and growth is expected to flatline for the remainder of the year.
Annual consumer price inflation, currently drifting back towards target, is forecast to climb to 4.1 per cent at the start of 2027. That, Niesr argues, will compel the Bank of England to lift Bank Rate to 4 per cent in July, rather than allow it to fall towards 3 per cent as markets had been pricing in only weeks ago.
“Even in a relatively benign scenario, where the conflict in the Middle East is resolved quickly from here, the shock is likely to have a material impact on the UK economy,” said David Aikman, director of Niesr.
The bond market is already drawing its own conclusions. Yields on ten-year gilts breached 5 per cent on Tuesday for the third time since hostilities began two months ago, the highest borrowing costs Britain has paid since the financial crisis. The benchmark briefly hit 5.07 per cent before settling at 5.03 per cent in the afternoon. Gilts were the worst-performing major asset class of the day, a stark reminder of the UK’s structural exposure to imported energy.
That repricing piles fresh pressure on Rachel Reeves. With higher inflation eating into the real value of departmental budgets, Niesr calculates a 4 per cent erosion by the end of the decade unless the Treasury tops them up, the chancellor faces what the institute politely terms “tough calls” at the autumn Budget. Translated for boardrooms across the country: expect the tax-raising conversation to begin again.
In the adverse scenario, the picture turns considerably bleaker. Inflation would remain stuck above 4 per cent, more than double the Bank’s 2 per cent mandate, and the Monetary Policy Committee could be forced to push borrowing costs up by a punishing 1.5 percentage points in short order. Stephen Millard, Niesr’s deputy director, described $140 oil as “severe but plausible”, warning that central banks would have to “respond big time” if it materialised.
For now, the MPC is expected to sit on its hands when it meets on Thursday, holding Bank Rate at 3.75 per cent while officials assess how the next round of energy price rises, due in June, ripples through wages and the labour market. The institute’s central concern is the spectre of “second-round effects”, pay settlements rising to compensate for higher bills and embedding inflation in the system, much as they did in 2022 and 2023.
For SME leaders, the message from Niesr is bracing but clear. The cost-of-doing-business crisis is not over; it has merely been paused. Hedging energy exposure, locking in financing where possible and stress-testing margins against another year of elevated rates ought to be back at the top of the boardroom agenda.
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Britain braces for £35bn energy shock as Iran conflict pushes inflation back above 4%