Iran war could see 5.8% inflation and cost Treasury up to £8bn a year – report

The Iran war could cost the Treasury up to £8bn a year through higher debt interest payments and lower tax revenues, according to a report.

Inflation could peak as high as 5.8% if the conflict in the Middle East ends up in a prolonged stalemate, new modelling by the Institute for Public Policy Research (IPPR) indicates.

This figure, measured by the Consumer Price Index (CPI), is well above the Bank of England’s 2% target.

As over a quarter of UK debt is index-linked, increased inflation directly results in higher debt servicing costs.

Meanwhile, the think tank warned that real GDP growth could fall as low as 0.3%.

The IPPR urged the Government to act to mitigate the risk of the US and Israel’s war with Iran causing long-term damage to the UK economy and public finances.

The report’s recommendations include introducing a temporary energy price cap at £2,000 to limit inflation, while maintaining incentives to reduce consumption.

The IPPR also suggested implementing a temporary 10p fuel duty cut to offset rising oil prices.

The think tank argued that these should be paired with measures to reduce energy demand, including lowering speed limits.

Finally, the IPPR urged the Government for “targeted, progressive” taxes, such as a strengthened windfall tax on energy profits.

This package of measures would cost up to £5bn per year depending on the severity of the shock, the report said.

The think tank argued this makes the policies, at worst, fiscally neutral, because the costs are offset by lower borrowing costs and protected tax revenues.

However, if the intervention succeeds in preventing permanent damage to the economy or avoid steeper interest rate hikes, the Government could save between £6-10 billion per year compared to doing nothing, according to the IPPR report.

The authors said these measures would demonstrate lessons learned from Liz Truss’s response to the 2022 energy crisis, which cost £76bn.

Senior economist at IPPR William Ellis said: “The UK cannot afford to sit back and let another energy shock drive up inflation and damage the economy.

“The UK economy and public finances are expected to take a significant hit from the Iran conflict, regardless of whether the Government intervenes.

“The Bank of England is not well suited to respond, given the lag that it takes for interest rates take to influence demand.

“However, as the Bank set out last week, it is still likely to increase interest rates to guard against second round effects and high inflation expectations – particularly if the conflict escalates.

“The Government can act now where the Bank can’t, with a well-designed policy that acts to cap prices only in the most damaging scenarios.

“At worst, this would save about as much as it costs – but if permanent damage or sharp interest rate rises are avoided, this could end up saving money.”

Associate director at IPPR Sam Alvis said: “A well-designed intervention, that pairs capping prices with clear incentives to reduce energy demand, would not only protect living standards but prevent the need for damaging interest rate rises, and insure against the risk of more severe damage.

“This is cost-effective, and if permanent damage is avoided, this actually saves the Government money.

“Keeping interest rates lower and investment higher prevents any damage to deploying and using clean energy, the long-term solution to crises like this.

“The lesson from Liz Truss is clear: it’s not intervention that spooks markets, it’s poor policy design and an ignorance of investors’ concerns.

“With the right approach, the Government can act decisively and responsibly at the same time.”