OBR cuts UK growth forecast as energy prices lift inflation

Bank rates and government borrowing costs are forecast to rise

The Office for Budget Responsibility has cut its forecast for UK growth next year to 1%, down from 1.6%, amid rising energy prices linked to the US-Iran war. Although the UK may have no involvement in that conflict, the OBR said higher energy bills were the biggest near-term risk to the economy in its first assessment since the Middle East conflict began. It also forecast a dip in household living standards next year as energy bills hit spending power, along with higher inflation and more expensive borrowing.

The downgrade for next year came even as the OBR raised its growth forecast for this year and projected a rebound in the following years. When an economy grows, businesses tend to invest more, create more jobs and give pay rises to workers, which leaves people feeling better off on average, though it can take time and not everyone necessarily benefits. Companies making higher profits also pay more in tax, which can enable the government to spend more on public services. When there is slow economic growth, or the economy shrinks, the opposite can occur.

Inflation can weigh on growth, and the OBR has forecast that prices are set to rise at a faster pace as higher energy bills filter through supply chains and to consumers, especially in 2027. Inflation is expected to average 3.4% next year, peak at 3.8% in 2027 and fall to the Bank of England’s 2% target toward the end of the decade. Prices are therefore expected to stay higher for longer than previously forecast.

The OBR said soaring energy prices would push up inflation and leave living standards in a “grim” place, and it has forecast a dip next year as energy bills hit the spending power of households. Real household disposable income, a measure of living standards, is forecast to grow from 2027, but not by as much as previously thought. Those on lower incomes are set to be hit harder because energy costs eat up a bigger share of their monthly budget and disposable income.

David Miles of the OBR said, “It’s a pretty grim picture,” adding that there has been “virtually no growth” for individuals since before the Covid pandemic. “It’s been a dismal period in British economic history,” he said.

Bank of England interest rates are widely expected to rise next week following higher inflation in recent months. They currently stand at 3.75%, while the OBR forecasts they could reach as high as 4.5% in coming years. The OBR had previously forecast two rate cuts this year. Higher rates can make borrowing more expensive while increasing returns on savings.

For the government, inflation and higher rates add to debt costs. Spending on debt interest is set to rise, and total borrowing is forecast to increase every year by more than the OBR previously expected. Higher spending on welfare and pensions due to inflation is also expected to increase borrowing, although borrowing as a share of the economy is forecast to fall over the next five years.

Chancellor John Healey announced policies that he said would give households “breathing space” in the coming months, while warning that the nation faces “real challenges ahead.” He said, “What we face today are global economic storms. We can’t wish them away. We must choose the course we steer through them.”

Economists at Pantheon Macroeconomics said the government’s cost-of-living measures were “small beer given the surge in inflation we expect over the winter.”

High global oil prices have already hit drivers at the pumps, with petrol priced at almost £1.73 per litre on average, while diesel is near £1.99. Elevated oil prices over time can lead to prices edging upwards across a host of goods, such as food, as companies pass on the higher expenses they face to consumers. Goods are typically transported to destinations by lorries and vans, so high fuel prices can have far-reaching consequences.

Forecasts remain estimates rather than certainties. Given the way the conflict in the Middle East has upended previous predictions, the future of the war could alter inflation expectations. President Donald Trump has suggested the war will end after the mid-term elections next month. The OBR acknowledged there remained “significant uncertainty” around its predictions due to the changing situation in the Middle East.

The result is a UK outlook marked by slower growth next year, inflation staying above target for longer, higher borrowing costs and a dip in household living standards next year, with real disposable income growing from 2027 by less than previously expected. Healey’s policies offer what he called “breathing space,” but the OBR expects lower-income households to bear more of the energy-cost burden.