Rachel Reeves is facing a potential £20bn shortfall in her spending plans as the Middle East energy crisis pushes up inflation, borrowing costs and pressure on public sector pay.
The warning from the Institute for Fiscal Studies (IFS) comes as surging oil and gas prices begin to feed through into the wider economy, threatening to derail the government’s fiscal strategy.
Economists said a sustained rise in energy prices could force the Treasury to spend billions more as higher inflation lifts welfare payments, wage demands and debt servicing costs.
The IFS estimates that uprating working-age benefits in line with higher inflation could add £2.5bn to the welfare bill next year alone, while pressure for higher public sector pay could add a further £4bn.
These costs would come on top of existing strains within Whitehall budgets.
Departmental spending plans are set in cash terms, meaning their real value is eroded by inflation, a gap the IFS said could require an additional £3bn just to maintain planned spending levels.
Inflation shock adds to debt burden
The biggest pressure, however, comes from debt servicing. A rise in inflation linked to higher energy prices could add up to £10bn to the cost of servicing the UK’s stock of index-linked debt, according to the IFS.
Taken together, the think tank estimates the total impact could reach £20bn, only partially offset by higher tax receipts.
The warning comes as oil markets remain volatile following escalating tensions in the Middle East.
Brent crude has traded above $100 a barrel in recent weeks, at one stage approaching $120, while gas prices have also surged amid disruption to supply routes.
The Bank of England has warned that an oil price around $100, combined with elevated gas prices, could push inflation to 3.5 per cent later this year, well above its two per cent target.
That would directly feed into government spending, as benefits are typically uprated in line with September inflation.
The Office for Budget Responsibility (OBR) had previously assumed a lower rate of 2.1 per cent.
Jagjit Chadha, at the University of Cambridge, warned that higher energy prices leave governments with limited room to manoeuvre.
“There’s no obvious alternative… the Government cannot endlessly subsidise prices that are set in world markets,” he said.
The UK’s debt servicing bill already exceeds £100bn a year, leaving little headroom for additional borrowing, and a sustained period of higher inflation could entrench these pressures for years.
At the same time, higher inflation may boost tax receipts through so-called fiscal drag, as frozen income tax thresholds pull more workers into higher bands.
Estimates suggest this could raise billions annually, though economists caution the effect may be limited if wage growth does not keep pace with prices.
The growing strain on the public finances comes as ministers weigh further support for households facing rising energy bills.
Keir Starmer is expected to convene senior ministers and Andrew Bailey to assess potential measures, though high debt levels are likely to constrain any large-scale intervention.
Opposition figures have called for alternative approaches. Kemi Badenoch has urged the government to cut green levies to reduce bills, arguing that borrowing to fund subsidies would risk fuelling inflation further.
The pressure on Reeves comes against a backdrop of broader energy insecurity across Europe, with policymakers once again grappling with price shocks similar to those seen after Russia’s invasion of Ukraine in 2022.
Despite efforts to diversify supply, global energy markets remain highly sensitive to geopolitical disruption.
The ongoing conflict has raised concerns about supply constraints through key routes such as the Strait of Hormuz, through which around a fifth of global oil flows.
