Reeves warned Iran war oil shock will lead to government borrowing spike
Chancellor Rachel Reeves has been warned that government borrowing is set to spike as a result of the Iran war as the Office for Budget Responsibility admitted it had underestimated the effects of the last energy price shock.
In a review of its forecasting models, the OBR suggested it had learned lessons from Russia’s full-scale invasion of Ukraine, which led to gas prices rising by around five times.
It said the overall impact on public finances “was to significantly increase government borrowing and debt” despite some government revenue being raised by taxes on energy companies’ profits and higher wage growth.
The surge in government borrowing was driven by a rise in debt interest costs, welfare benefits and the maintenance of real-terms increases to departmental budgets, according to analysis.
The OBR concluded that it would apply the lessons from its forecast review to the energy price shock caused by the Iran war at this year’s Budget.
The analysis suggests that the OBR could take a more pessimistic view on government borrowing, with oil prices jumping by around 40 per cent since the beginning of the war in March and wholesale European gas prices doubling.
Economists have warned that stalled peace negotiations will lead to prolonged disruption across the Strait of Hormuz, a critical global trading route for oil tankers and large ships.
The Bank of England warned in a worst case scenario analysis that continued disruption would push inflation above six per cent and force it to undo all interest rate cuts made in the last two years.
OBR builds on previous analysis
In 2024, when Iran and Israel appeared to be close to an all-out war, the OBR conducted an initial analysis of what disruption could mean for UK public finances.
The OBR then estimated that the UK government would have to borrow an average of £23.1bn more a year if there were a cut to energy supplies “comparable to the 1973 oil embargo”, Morning Wire found.
Economists have widely suggested that the current blockade on the Strait of Hormuz, triggered by the Iran war, is the worst global oil supply shock recorded in history. International Energy Agency chief Fatih Birol said it was more serious than supply shocks in “1973, 1979 and 2022 together”.
Under the OBR’s assumption, oil and wholesale gas prices would remain 75 per cent higher over the course of a year.
Peace talks between the US, Israel and Iran appear to be on ice after Israel restarted attacks in Lebanon against an Iranian-backed militant group. Israel then paused its attacks on Hizbollah as President Trump reportedly told Prime Minister Netanyahu “everybody hates Israel because of this”.
The Brent Crude Oil price fell to $85 per barrel on news of a possible return to peace negotiations, although trading prices have been volatile due to uncertainty over possible peace terms. The price climbed as high as $114 per barrel last month.
Reeves’ package to have minimal effect
Alongside assessments of the Iran war’s impact on the UK economy, the OBR is also expected to update forecasts based on any energy support package unveiled by Reeves or any following Chancellor.
Analysis by JP Morgan found that initial action to offer families discounts and to freeze a fuel duty hike would strip 0.2 percentage points off inflation.
The OBR said on Tuesday it would also tweak its models for forecasting business tax receipts and local authority expenditure.
It will also revise the link between higher unemployment and benefits.
Economists at the independent body also hit back at Labour MPs who suggested that models for forecasting the growth effects of extra public expenditure were skewered, claiming it was “unlikely” that calculations were misguided given that the UK economy had underperformed despite a surge in government spending.