INFLATION
Iran conflict pushes inflation back to 3.5%
Inflation has been below 3.0% for two consecutive months, the first time this has happened since March 2025. Unfortunately, it won’t last. Energy prices will continue to fuel inflation, with a big hike to the energy price cap in July pushing inflation back above 3.0% even as pump prices ease, before peaking close to 3.5% towards the end of the year.
However, the economy is much weaker than when entering the last energy shock in 2022, which should limit second-round effects such as firms passing on energy costs, and prevent a rerun of the double-digit inflation of 2022.
Slower inflation won’t last long
Inflation dropped down to 2.8% in April as the Government used the previous budget to cut energy bills and last year’s swathe of regulated price hikes dropped out of the annual comparison. However, the conflict in Iran has sent oil prices soaring, which pushed up motor fuel inflation.
Without the conflict inflation would be almost at the 2.0% target.
What will cause inflation to rise again?
Energy prices
Ofgem’s energy price cap will rise by 13% in July, driven by the higher wholesale gas prices from the Iran crisis. Based on current market pricing for future deliveries of gas, we expect the cap to fall a little in October. But the main risk is that wholesale gas prices surge again as demand ramps up into the colder months.
Indirect impact of energy prices
Higher energy prices will also filter through supply chains, pushing up food, manufactured goods and airfares inflation.
Fertiliser and plastic packaging
The Middle East is an important supplier of fertiliser and plastic packaging, which will compound the impact on food inflation. The UN wholesale food price index has already risen by 4.1% since the conflict began in February. This will feed through to supermarket shelves, with the Food and Drink Federation warning that food inflation could peak as high as 10% by the end of the year.
Will inflation this year mirror 2022?
The good news is that we aren’t expecting a repeat of 2022, when a perfect storm of rebounding demand, post-pandemic supply chain disruption and surging energy prices due to the invasion of Ukraine pushed inflation above 11%.
The labour market is weaker this time around, so employees will struggle to secure inflation-beating pay rises. Since wages are the biggest cost for most services firms, we expect services inflation to hold around 3.7% this year and next. Similarly, the weaker demand backdrop will limit firm’s ability to pass on price increases as aggressively, restraining any second-round effects on inflation.
As a result, inflation should slow sharply to around 2.5% next spring before returning to target later in 2027 as the energy price spike fades.
Ultimately, our base case is that inflation will peak close to 3.5% this year and remain elevated into Q1 2027, before dropping back sharply as more favourable base effects and a weaker labour market help to bring inflation back to target.
