UK inflation seen at 2.3% in 2026; OBR flags war energy risk

The UK’s fiscal watchdog expects inflation to fall to an average of 2.3% in 2026, lower than predicted in November, as weaker economic activity and lower food and energy prices ease cost pressures.

However, it has warned that escalating conflict in the Middle East "could have very significant impacts on the global economy, particularly energy markets."

In its latest economic and fiscal outlook, the Office for Budget Responsibility said consumer price inflation is projected to fall from 3.4% in 2025 to an average of 2.3% in 2026, before stabilising at 2.0% from 2027 onwards.

The 2026 forecast is 0.2 percentage points lower than predicted in November.

Chancellor Rachel Reeves, presenting the updated forecasts to parliament on Tuesday, said inflation readings had come in lower than expected in recent months and were likely to fall close to the Bank of England’s target as early as April.

Slower wages and lower energy prices ease pressure

The OBR attributed the improved inflation outlook to “greater slack in the economy” and easing food and energy costs.

Market expectations for gas prices have fallen by 15% on average since November, the watchdog noted.

Slowing wage growth is also expected to contribute to the cooling in prices.

Nominal weekly pay growth is forecast to slow to around 3.5% in 2026 and then average 2.25% annually thereafter, broadly in line with previous projections.

The moderation reflects weaker labour market conditions, lower inflation and the gradual pass-through of last year’s increase in employer National Insurance contributions.

In November, when Reeves delivered her full Budget, the OBR had forecast inflation of 2.5% this year.

Since then, price data has surprised to the downside, offering the government a measure of relief after a prolonged cost-of-living crisis.

Middle East conflict clouds outlook

Despite the improved near-term picture, the OBR stressed that geopolitical risks remain acute.

The report warned that conflict in the Middle East, which escalated as the document was finalised, “could have very significant impacts on the global economy, particularly energy markets”.

Benchmark European gas prices surged more than 40% on Monday, while Brent crude oil jumped 6% amid fears of supply disruptions.

Economists had cautioned ahead of the forecast that rising global energy prices could undermine Reeves’s efforts to curb inflation and revive growth.

“Just when Reeves thinks the economy is on a slightly more even keel, the government is now confronting a crisis that’s completely outside its control and it creates another massive headwind,” said Mujtaba Rahman of consultancy Eurasia Group.

“The two areas they’ve trumpeted the most are the cost of living and interest rates, and those are the two areas of the economy that are now most at risk.”

Growth downgraded, unemployment expected to peak in 2026

While inflation is expected to ease, the growth outlook has softened.

Real GDP is forecast to expand by 1.4% in 2025 before slowing to 1.1% in 2026, 0.3 percentage points lower than projected in November.

The downgrade reflects weaker-than-expected output data in late 2025, further loosening in the labour market and subdued business surveys.

The OBR said it judged the weakness to be cyclical, suggesting greater spare capacity in 2026 than previously assumed.

Growth is then forecast to pick up modestly to 1.6% in both 2027 and 2028, slightly higher than earlier projections, before easing to 1.5% in 2029 and 2030.

Unemployment is expected to rise to a peak of 5.3% in 2026 before gradually falling to an estimated equilibrium rate of 4.1% by 2030.

The watchdog said labour market weakness appears to be driven mainly by new entrants struggling to find work amid subdued hiring demand.

Simon Gleeson, a partner at Blick Rothenberg, said downgraded growth forecasts and rising unemployment were “not a good headline for government”.

He added that the chancellor had chosen to emphasise her economic plan rather than focus on the deterioration in near-term growth.

Borrowing improves but markets uneasy

The forecast showed public borrowing is set to fall nearly £18 billion compared with the Autumn statement, with borrowing this year projected to be the lowest in six years and below the G7 average for the first time in 22 years.

Headroom against the government’s stability rule has increased to almost £24 billion.

Financial markets reacted nervously to global developments.

Under normal circumstances, a forecast showing borrowing falling faster than anticipated in November would have helped ease government borrowing costs.

Instead, turmoil has gripped bond markets, with investors unsettled by the Iran conflict and a surge in energy prices.

UK government bond prices have dropped sharply, sending the yield on 10-year gilts up by almost 16 basis points, or 0.16 percentage points, in a pronounced move.

Two-year gilt yields, which are closely tied to interest rate expectations, have also risen by 16 basis points to 3.79%.