Rising Oil Prices Tighten Fiscal Constraints for UK Ahead of Healey Budget

Despite Healey's efforts to project confidence about the UK's economic outlook, Treasury insiders concede that the steep rise in energy prices has reduced the government's financial flexibility. Officials are said to be working rapidly on a set of possible measures to cushion consumers, particularly if elevated prices continue feeding through into a significant increase in the quarterly energy price cap in January.

A sharp climb in oil prices on Thursday is adding pressure on UK policymakers as Chancellor John Healey prepares to deliver his budget next month, with Treasury sources acknowledging they now have "less room" than a month ago.

Any support package is expected to fall well short of the sweeping subsidies introduced by Liz Truss in 2022. The Treasury is mindful of steps already taken, including Andy Burnham's VAT cut on electricity bills. Options under consideration are believed to include moving some green subsidies into general taxation — an approach previously used by Rachel Reeves — or directing assistance specifically at the lowest-income households, though some officials doubt how effectively such targeting can be delivered.

Oil Prices Rise on Middle East Clashes

Brent crude was trading at around $108 per barrel on Thursday, up nearly 5%, following reports of further military exchanges between Saudi Arabian and Houthi forces. US President Donald Trump has offered little clarity on how or when the broader US-Israeli conflict with Iran might end, despite rising gasoline prices in the United States ahead of key midterm elections.

Senior UK government figures are also growing uneasy about the possibility of interest rate increases, which could push up mortgage costs at a time when Burnham has pledged to give voters "breathing space". The Bank of England, which held rates at 3.75% last week, said it expected the energy price cap to rise by as much as 24% in the new year.

Bank of England Flags Rate Rise Risk

The Bank's chief economist, Clare Lombardelli, warned in a speech on Thursday in Warsaw, Poland, that the longer oil prices stayed elevated because of the conflict, the more likely it was that rates would need to increase. "The longer higher energy prices persist, the greater the risk that indirect effects build and that inflation expectations, wage bargaining and price-setting behaviour begin to adjust in response," she said. "On that basis, policy is increasingly likely to need to tighten if elevated energy prices persist, absent clear evidence of disinflation or weaker activity."

Her warning was echoed by Bank of England deputy governor and monetary policy committee member Sarah Breeden, speaking at a conference at Imperial College London: "The larger and longer the shock, the more likely it is that we'll see the material second-round effects that policy needs to respond [to]."

Bond Markets Sell Off as Yields Rise

Expectations of higher inflation and interest rates driven by rising energy costs are a central factor behind a global sell-off in government bond markets, pushing up borrowing costs for the UK and other economies. The yield on 10-year UK gilts climbed to 5.39% on Thursday, nearing a 19-year high recorded the previous week.

Higher interest rates increase the upfront cost of government investment and affect Office for Budget Responsibility projections of whether the chancellor is on track to comply with Labour's fiscal rules. Analysts estimate that recent yield increases have erased more than half of the £24bn headroom against those rules that Reeves had accumulated at the time of the spring statement in March.

Healey has repeatedly pledged to meet the fiscal rules with a "buffer against uncertainty", though that buffer is widely anticipated to come in significantly below £24bn. Restoring it to that level would likely require substantial tax rises or spending cuts, although Treasury sources maintain the budget will be narrowly focused.

Investors across major markets have been offloading bonds in recent weeks as the Middle East conflict continues. As the sell-off deepened on Thursday, the yield on 10-year US Treasury bonds surged to 5.17%, the highest level since 2007. Beyond inflation concerns, investors appear to be worried about the risks of unchecked US government spending, while some analysts also point to large-scale bond issuance by artificial intelligence companies as a factor suppressing demand for Treasuries.