The renewed conflict in the Middle East has intensified pressures on the UK economy, with forecasts warning of slower growth and tighter fiscal constraints ahead of the autumn budget. Rising global oil prices, which have surged above $100 a barrel for the first time since May, are expected to dampen economic activity and reduce the government's financial flexibility, according to projections from the EY Item Club.

This deterioration stems from the breakdown of a ceasefire between the United States and Iran and the subsequent escalation of hostilities in the Red Sea, where Yemen’s Houthi rebels have targeted Saudi tankers. These developments have caused oil prices to spike, feeding into higher energy costs domestically and abroad.

The EY Item Club, which employs economic models used by the Treasury, forecasts that UK GDP growth will slow to 0.9% in 2026, down from 1.3% in 2025, and weaken further to 0.7% in 2027. This would represent the slowest sustained growth since pandemic-related lockdowns ended in 2023. Rising energy prices are exerting additional pressure on households and businesses, compounding already subdued demand.

Matt Swannell, chief economic adviser to the Item Club, described the outlook as a “sustained period of weak growth” with limited relief expected from external economic factors. He cautioned that while the economy will continue to expand, progress is likely to be significantly slower compared to recent years.

The forecast presents challenges for the government, particularly for John Healey, the new chancellor preparing his first budget. The combination of higher oil prices, an increasingly expensive borrowing environment, and slower growth threatens to reduce the fiscal headroom established by Rachel Reeves in her last budget, which initially left a £23 billion buffer under Labour’s fiscal rules.

Independent estimates suggest that this fiscal space may have shrunk considerably, with the Resolution Foundation putting the remaining headroom at around £7 billion, while Swannell estimates a reduction to just over £17 billion. This contraction in fiscal leeway could compel Healey to consider tax increases or spending cuts to meet Labour's fiscal targets.

The government has already committed to a £4 billion increase in defence spending by the end of the decade, though £1 billion of this remains unfunded. Given the tighter fiscal outlook, expanding expenditure significantly within the current framework may prove difficult.

Inflation is projected to peak at 3.5% this year, driven in part by the higher oil prices that are anticipated to push up Ofgem's energy price cap in the latter half of 2026. Meanwhile, unemployment is expected to rise from 5% to 5.5%, adding some 200,000 individuals to the jobless ranks.

Swannell also noted that the Bank of England is likely to maintain its base interest rate at 3.75% for the foreseeable future amid these conditions. The Bank’s upcoming policy decision scheduled for Thursday is widely anticipated to leave rates unchanged.