The UK is set for the biggest hit to growth from the Middle East war among the group of seven rich nations as the economy faces stagflation, new forecasts from the International Monetary Fund show.
The surge in energy prices since the start of the conflict will also propel inflation to double the Bank of England’s target, the fund said in its latest economic outlook on Tuesday.
Britain relies heavily on imported gas to heat its homes and fuel its businesses, the price of which has surged since the outbreak of the war. The IMF expects spending to slide in response to higher energy costs, causing the UK economy to suffer a sharper downturn relative to its peers.
Growth is forecast to be 0.8 per cent, 0.5 percentage points slower than the fund’s January prediction of 1.3 per cent growth and the largest downgrade of any G7 nation.
The IMF expects growth of 1.3 per cent in 2027, down from 1.5 per cent previously. The UK economy grew by 1.4 per cent last year after being recently revised higher by the Office for National Statistics.
Inflation is on track to average 3.2 per cent in 2026 and head towards 4 per cent, the joint-highest rate of price growth with the United States in the G7. The IMF does not expect inflation to return to the Bank of England’s 2 per cent target until the end of next year, signalling that interest rates are unlikely to be lowered and may even be increased to tame rising prices, dealing a blow to millions of homeowners across the country.
The last time the UK faced stagflation — low growth and rising inflation — was in 2022 and 2023 after the Russian invasion of Ukraine.
The conflict could plunge the world “into the largest energy crisis in modern times” if all sides continued to escalate attacks on one another, the IMF warned on Tuesday. The fund’s report comes at the start of President Trump’s naval blockade of the Strait of Hormuz with the conflict in its sixth week.
Global growth will also be 0.2 percentage points weaker this year at 3.1 per cent due to shortages of commodities, higher energy prices and an erosion of living standards, the IMF said, before picking up slightly to 3.2 per cent next year.
In a severe downside scenario in which there is yet more substantial damage to energy infrastructure in the Middle East, growth would fall to just 2 per cent, putting many economies on the brink of a recession, the organisation warned. Inflation would exceed 6 per cent.
“Geopolitical tensions could worsen even more than they already have — turning the situation into the largest energy crisis in modern times — or domestic political strains could erupt”, the IMF said.
Rachel Reeves, the chancellor, faces pressure to support families facing another rise in energy bills this summer due to the war.
“The war in Iran is not our war, but it will come at a cost to the UK. These are not costs I wanted, but they are costs we will have to respond to. I have vowed that my economic approach to this crisis will be both responsive to a changing world and responsible in the national interest, keeping inflation and interest rates in check to protect households and businesses,” said Reeves, who is in Washington for the latest IMF annual meeting, on Tuesday.
“We entered this conflict in a stronger position because of the choices this government took to build economic stability, but there is more to do. That is why we are strengthening Britain’s energy security, backing British industry and protecting households, to build a Britain that is stronger, more resilient, and prepared for the future,”.
However, the IMF cautioned against repeating the universal support launched by former prime minister Liz Truss after Russia’s invasion of Ukraine in 2022 at a cost of around £80 billion.
Pierre-Olivier Gourinchas, the IMF’s chief economist, said: “Untargeted measures — price caps, subsidies, and similar interventions — are popular. But they are frequently poorly designed and costly. Given the lack of fiscal space with still elevated budget deficits and rising public debt, any fiscal support should remain narrowly targeted and temporary.”
Rachel ReevesJack Taylor/Getty Images
He added: “Too often, this lesson was missed in 2022; countries should do better this time.”
So far, the government has only stepped in to help rural households that use heating oils, the price of which has surged since the outbreak of the Gulf conflict.
Central banks should embark on a “swift tightening” of interest rates if inflation threatens to get out of hand, the chief economist said.
Since the US and Iran announced a two-week ceasefire last week, investors have scaled back their expectations for interest rate rises this year, although this is likely to be reversed if the deal fails to hold. Oil prices leapt back above $100 a barrel on Monday after peace talks between the US and Iran in Pakistan failed to yield an agreement.
The IMF’s forecasts indicated that the US economy would prove resilient to the war. Growth was projected to be just 0.1 percentage points slower this year at 2.3 per cent and then 0.1 percentage points faster than previously expected at 2.1 per cent next year.
Germany was projected to grow by 0.8 per cent in 2026, down by 0.3 percentage points compared to the IMF’s previous forecasts in January. Europe as a whole was anticipated to expand by 1.1 per cent and 1.2 per cent this year and next, downgrades of 0.2 percentage points in each year.
Russia is set to grow more quickly this year and next because it benefits from the higher oil prices brought on by the conflict. China will grow by 4.4 per cent and 4 per cent in 2026 and 2027 respectively, a slight downgrade, the IMF said.
“The latest war underscores that the international order is under growing strain, with fraying alliances, new conflicts, and national-security concerns shaping economic policy”, Gourinchas said.
IMF warns of financial ‘cascade’ as AI and war hit lending
Further failures in private credit could “cascade” through the global financial system as the sector faces its first real “convergence” of risks ranging from the war in the Middle East to investors fleeing the market, the International Monetary Fund has warned.
The IMF said that another round of defaults by businesses that borrowed from private credit firms could lead to “broader concerns about corporate credit”.
Companies whose profits are most at risk of artificial intelligence making their business models redundant are likely to struggle to repay debts extended to them by private credit companies, the fund warned.
The comments, contained in the body’s global financial stability report released on Tuesday, are the latest in a long line of warnings from the world’s foremost financial watchdogs, who are increasingly concerned that the private credit market could be the catalyst for the next financial crisis.
Earlier this month Andrew Bailey, the Bank of England governor, said that hidden “lemons” in the private credit industry risked causing investors to lose faith in the market altogether in a similar fashion to the loss of confidence in the sub-prime market during the 2008 financial crisis. Previous warnings have come from the Bank for International Settlements and the UK’s Prudential Regulation Authority.
Speaking at an event at the IMF’s spring meetings in Washington on Monday, Paul Atkins, head of the US Securities and Exchange Commission, said that retail investors should “get out of the kitchen” if they cannot “take the heat” in reference to investing in private credit.
The sector rose to prominence in the wake of the 2008 global financial crisis after more red tape was imposed on the lending activities of high street banks. During the low interest rate environment in the run-up to the pandemic, investors were attracted to the higher yields by the industry, and private credit outfits have sought to capitalise on the AI boom by financing the building of infrastructure.
Business newsletter
The business editor’s exclusive analysis of all the latest financial and economic news.
Sign up with one click
However, a series of failures by borrowers that relied on financing from the sector have ignited a wave of withdrawal demands from investors in private credit funds.
Blue Owl, Apollo Global Management, Ares Management and BlackRock all capped withdrawals at 5 per cent in the first three months of the year. The IMF said that withdrawal demands reflected investors’ concerns about “borrower credit quality”.
The IMF warned that the sharp increase in bond yields globally, the surge in energy prices and stock market volatility engineered by the war in the Middle East represented the private credit sector’s first real shock and it was unclear how it would hold up.
Tobias Adrian, director of the monetary and capital markets department at the IMF, said: “Private credit is an important area of focus. Rapid growth in direct lending has made the sector more important to the overall economy and financial system, while opacity, valuation practices, short‑term funding backed by longer‑term assets, and rising defaults pose challenges.
“While these vulnerabilities have not yet been tested by an adverse shock, their presence means that the system is more exposed, even if markets have remained orderly so far.”
While Adrian recognised that financial markets have so far withstood the Middle East shock, he said that such “resilience should not be taken at face value … it reflects cycles of escalation and de-escalation, structural improvements in the financial system, and the absence of a decisive adverse turn that would trigger sustained market drawdowns”.
The Gulf conflict could result in “booming investments in AI [to] slow significantly if the conflict in the Middle East were to persist”, the IMF’s report warned.
Other potential sources of stress in the global financial system included “gyrations” in global bond markets on days when governments sold these instruments and elevated borrowing among hedge funds to purchase such bonds.
“Fiscal stances should shift toward appropriately tight settings to place public debt on a stable path, with new spending focused on protecting vulnerable groups from the inflation shock,” the IMF said.