Key Takeaways
- A repeat of the pandemic-era inflation surge is unlikely, but near-term energy prices will place upward pressure on UK CPI this year.
- We still expect the Bank of England to cut interest rates to 3.50% later in 2026.
- UK economic growth is set to slow in 2026 but to recover in the following years.
The jump in energy prices since the outbreak of war in the Middle East in late February 2026 has caused investors significant unease. Indeed, gilt markets have fretted about the potential for a near-term spike in UK inflation and the potential for associated monetary policy tightening.
Not so distant memories of 2021-22 have been invoked, when supply-chain bottlenecks, energy prices, and fiscal stimulus jointly conspired to send inflation surging. Financial conditions have tightened, with swap markets now pricing in Bank of England interest rate hikes, departing from the prewar outlook for one to two cuts by year-end.
Outlook at a Glance: UK Economy 2026
- UK inflation to fall to 2.2% by end-2026
- UK growth forecast at 0.8%
- Bank of England to cut rates to 3.5% in late 2026
While the Middle East war remains highly dynamic, we see the macroeconomic consequences for the UK as manageable. The shock should prove stagflationary, shaving off around 0.2 percentage points of growth for the UK economy in 2026 as household disposable incomes take a hit from a midyear inflation spike. While headline inflation will tick up in mid-2026, the energy price shock will prove nonetheless transitory, with inflation likely to recede back into the “neighborhood” of 2% by year-end.
Markets Price Rate Hikes—but BoE Cuts Still Likely This Year
Despite energy market developments, we see one 25-basis-point cut to the Bank of England’s policy rate on the cards in 2026, likely in late 2026. We see fears of a rate hike by the BOE as overdone, given the tendency for central banks to “look-through” energy shocks. A presently weak labor market further mitigates the risk of rate hikes, in our view.
We’ve raised our growth forecast for 2026, anticipating average economic growth of 0.8% in the year ahead. Ultimately, last year’s budget shaped up as less of a near-term growth headwind than we’d previously anticipated, leading us to lift our growth outlook for 2026 from our prior forecast of 0.5%.
Still, growth is set to sequentially slow, as a mid-2026 inflation spike and a weak labor market weigh on consumption. An uncertain economic environment and slower rate cuts are likely to weigh on business and residential investment in 2026. We expect growth to recover cyclically thereafter.
A revised government spending outlook accounts for the lion’s share of our GDP growth forecast revisions over 2027-30. Updated fiscal forecasts suggest higher government spending in 2027 than we previously factored, and lower spending in subsequent years.
The Inflationary Impact of the Iran War Will Be Temporary
We’ve lifted our 2026 inflation forecast to reflect the likely impact of the present oil and gas supply disruption in the Middle East on UK price growth. While price growth won’t slow quite as much as we’d expected in 2026, the disinflationary process remains underway in the UK, with price growth still expected to largely normalize by 2026 year-end.
Thereafter, we continue to expect softening domestic conditions to weigh on price growth over the 2027-28 period. The expected unwinding of the recent spike in energy prices places an additional increment of downward pressure on price growth during this period.
We expect economic growth to recover over the 2026-30 period as the UK economy shakes off pandemic-related labor force participation headwinds. A cyclical recovery in the labor market also contributes. We also expect labor productivity growth to recover from its postpandemic and Brexit slump over the longer term. The adoption of artificial intelligence technology should further hasten productivity growth over the 2031-35 period.
We don’t think the Middle East war alters the calculus for the BoE’s monetary policy committee dramatically this year, assuming it proves short-lived. Still, surging energy prices mean that disinflation is likely to play out more gradually in 2026 than we’d previously anticipated. This reality—and that some MPC members still hold concerns around the potential for second-order effects from above target inflation—is likely to see a somewhat more cautious BoE in coming quarters.
Why the BoE Can Afford to Look Through Rising Inflation
Still, we expect one 25-basis-point cut to the BoE bank rate to eventuate, likely in the second half 2026. This contrasts with what we view as an overreaction in interest rate swap markets—which now price in interest rate hikes in 2026, versus the one to two cuts that were priced in before to the early March surge in energy prices.
Surging energy prices represent the most typical of supply-side shocks in the sense that they tend to be stagflationary in nature but nonetheless transitory. For this reason, with such a move doing little to lower energy prices set in global markets. Moreover, the slack, which now exists in UK’s labor market, should also limit the risk of second-order effects from the energy price spike, lowering the likelihood of an interest rate hike.
Undoubtedly, elevated near-term energy prices will naturally place some upward pressure on UK prices in the coming quarters. Even so, we still expect UK inflation will remain on its downward trajectory in 2026, as weaker domestic conditions bear down on price growth. We expect annual headline CPI inflation to drop to 2.2% by year-end 2026 despite the early 2026 spike in energy prices, down from 3.3% a year earlier.
This article is taken from the UK Economic Outlook, published in March 2026.
