Britain’s small and medium-sized businesses are on the verge of returning to the inflationary trenches they thought they had left behind.
According to new modeling from the National Institute of Economic and Social Research (Niesr), the war in Iran and the resulting blockage of the Strait of Hormuz will blow a £35 billion hole in British output over the next two years, push consumer price inflation back above 4 percent and force the Bank of England to raise interest rates rather than cut them.
That is the optimistic reading. The fighting is expected to end soon and the price of crude oil, currently trading at around $110 a barrel, will fall back to $65 by the end of next year. If the conflict drags on and oil prices rise to $140, a level last seen in the run-up to the 2008 crash, the damage will double to £68 billion and Threadneedle Street could be forced into the steepest emergency tightening since Black Wednesday in September 1992.
For the owner-managed businesses that make up the bulk of the UK economy, the impact is uncomfortably familiar. Energy bills are trending upward again, household budgets are tightening just as confidence has rebounded, and borrowing costs, already a millstone for growth-stage companies, are unlikely to fall before the fall.
Niesr has cut its UK growth forecast for 2026 to 0.9 percent, after forecasting 1.4 percent in February. The momentum at the beginning of the year was real: gross domestic product grew by 0.5 percent in the three months to February and is at a respectable level of 1 percent in the first half of the year. The trouble starts in the second. As fuel and energy costs impact household bills, consumers’ purchasing power will erode and growth is expected to stagnate for the remainder of the year.
Annual consumer price inflation, which is currently moving back towards its target, is expected to rise to 4.1 percent in early 2027. Niesr argues that this will force the Bank of England to raise the key interest rate to 4 percent in July, rather than letting it fall towards 3 percent, as markets had priced in just weeks ago.
“Even in a relatively benign scenario where the conflict in the Middle East is quickly resolved from here, the shock is likely to have a significant impact on the UK economy,” said David Aikman, director of Niesr.
The bond market is already drawing its own conclusions. The 10-year Treasury yield topped 5 percent 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 reached 5.07 percent before settling at 5.03 percent in the afternoon. Gilts were the worst-performing asset class on the day, a clear indication of the UK’s structural dependence on energy imports.
This reassessment increases the pressure on Rachel Reeves. Niesr expects higher inflation to reduce the real value of ministries’ budgets by 4 percent by the end of the decade, unless the Treasury increases them. The Chancellor is confronted with what the institute politely describes as “tough demands” in the autumn budget. Translated for boardrooms across the country: Expect the tax hike discussion to begin again.
In the negative scenario, the picture becomes significantly bleaker. Inflation would remain above 4 percent, more than double the bank’s 2 percent mandate, and the monetary policy committee could be forced to raise borrowing costs by a punitive 1.5 percentage points in the short term. Stephen Millard, deputy director of Niesr, described the $140 oil price as “severe but plausible” and warned that central banks would have to “react with great speed” if it came about.
The MPC is expected to hold its key interest rate at 3.75 percent at its meeting on Thursday while officials assess how the next round of energy price hikes, due in June, will affect wages and the labor market. The institute’s central concern is the specter of “second-round effects,” i.e. rising wage deals to offset higher bills and the embedding of inflation into the system, similar to what happened in 2022 and 2023.
For SME leaders, Niesr’s message is encouraging but clear. The cost of doing business crisis is not over yet; it was just paused. Hedging energy risk, securing financing where possible and reviewing margins for another year of increased interest rates should be back at the top of the board meeting agenda.
