Rachel Reeves pledged on Monday to be both “responsive” to rising living costs for households and “responsible” with the public finances as the UK government seeks to manage the economic fallout of the Iran war. 

But the chancellor held back from any big new promise of support to shield consumers from rising energy bills, instead relying on regulators to prevent price-gouging at the petrol pumps as ministers pursue international efforts to defuse the crisis.

Economists said Reeves could hold fire for now, since higher global prices would not hit household bills until July. But if the crisis continues, she will come under growing pressure to step in against a difficult fiscal backdrop. 

How vulnerable is Britain to an energy shock?

Britain is more exposed than many other European economies to the latest movements in energy markets because it combines greater reliance on natural gas with limited storage capacity.   

It is also entering the new energy shock with a bigger hangover from the last than other countries. Consumer price inflation of 3 per cent in January remained above the Bank of England’s 2 per cent target, and household expectations of future inflation remain higher than before the coronavirus pandemic. 

This makes it difficult for the BoE to “look through” the temporary impact of higher wholesale energy costs, even if it expects inflation to subside once the geopolitical crisis passes.

Instead, traders are already pricing in a probability that the next movement in interest rates will be up, in a reversal of bets on further cuts — with a knock-on effect on the cost of public borrowing. The yield on two-year gilts has risen by about 0.4 percentage points to roughly 4 per cent since before the war started.

When will higher prices hit households and businesses?

The most immediate impact on consumers comes from higher petrol prices: unleaded petrol has already increased by almost 5p per litre since the US and Israel launched their first attacks on Iran. 

Higher gas prices will feed through to household utility bills in July, when regulator Ofgem will put in place a new price cap based on average futures prices between February 18 and May 18. The price cap limits the costs that households pay per unit of energy, meaning actual annual bills can be higher or lower depending on usage.

Any business with an energy contract expiring in the short term will have to renegotiate at higher prices immediately, however. This means that a sustained rise in prices will gradually push up prices for other goods and services as companies pass these costs on to consumers. 

The precise impact will depend on how long energy prices remain high. Rob Wood, chief UK economist at consultancy Pantheon Macroeconomics, said the war made it likely that inflation would fall less than expected in the spring and rise above 3 per cent again later in the year. 

Reeves’ hopes — and those of the BoE’s rate-setters — of hitting the inflation target would “have to wait for another year if commodity prices are sustained at or around recent levels”, Wood added.

Will the government need to step in?

The UK is not yet in the acute situation seen at the height of the Ukraine price shock.

Analysts at investment bank Citi say the latest market pricing implies the cap on average household bills will rise to £1,985 in July — up from £1,758 at present but well below the peaks reached in 2022 and 2023. Energy costs for businesses are also well below previous peaks. 

But households are in a fragile position to withstand any new shock. Official forecasts are for rising unemployment in the near term and very weak growth in incomes over the next five years, while energy bills are still 60 per cent higher than before Russia’s full-scale invasion of Ukraine. 

“The government must stand ready to pull out all the stops and shield households and firms,” Paul Nowak, general secretary of the Trades Union Congress, urged on Monday. 

What support did the government give households last time? 

Ministers spent almost £80bn on energy support for households and businesses in the two fiscal years after the start of the Ukraine war, according to estimates published by the Office for Budget Responsibility in 2023. That is equivalent to more than 3 per cent of a single year’s GDP.

The UK’s package of support included a 5p cut in fuel duty, discounts and caps on all household bills, council tax rebates for most, further support for those on benefits and separate relief for businesses.

This made it one of the most expensive in Europe, the fiscal watchdog said, before netting off the revenues flowing in over time from windfall taxes on oil and gas companies. 

Research by the Institute for Fiscal Studies think-tank, released last year, found the government could have achieved its aims at much lower cost if it had targeted payments on households with low income and high energy use, rather than offering universal subsidies that gave people no incentive to save energy. 

“Protecting household incomes in this way is not costless,” Helen Miller, IFS director, warned last week, describing it as “a key reason that debt has been rising in recent years”.

Can ministers afford to shield households again?

Holding the cap on energy bills at its current level for all households would cost between £5.9bn and £6.4bn a year, based on market pricing on Monday, according to Callum MacLaren-Stewart, economist at Citi.

In theory, this means Reeves has fiscal space to act, given the OBR’s forecast that the government retains £23.6bn of “headroom” against its fiscal rule of running a balanced current budget.

But the tax take is already set to rise to a postwar high as a share of GDP and Reeves’ plans to cut borrowing by the end of the decade depend on reining in spending in many areas of public services in the run-up to the next election — even if they are not derailed by other pressures, such as lower net migration or the need to fund new defence expenditure. 

“The fiscal position is likely worse than the official forecasts,” MacLaren-Stewart said, pointing to moves in energy prices and government borrowing costs since the OBR updated its forecasts last week.

Any new state support for households should be delivered by measures to lower the “policy costs” embedded in energy bills, he added, because this would also help to bring down headline inflation and lessen pressure on the BoE to keep rates higher for longer. 

For now, though, amid continued drone and missile strikes across the Middle East, analysts said it made sense for ministers and officials to take their time to decide the best way to deliver any new help. 

New support might be needed later in the year, when the energy price cap changed and cold weather arrived, said James Smith, chief economist at the Resolution Foundation think-tank. But the government “should not rush to announce new policy measures until it has a clear sense of how the conflict in the Middle East will affect living standards”, he added.

Additional reporting by Rachel Millard in London