IMF raises UK outlook but warns political turmoil could hurt growth

* IMF lifts UK 2026 growth forecast to 1.0% from 0.8% in April

* Upgrade due to stronger performance in ​late 2025 ⁠and early 2026

* 'Domestic uncertainty' poses threat to future UK growth

* Inflation expected to peak ​at just under 4% late this year

* No need for BoE rate hike if oil prices ease as job market weak

LONDON, May 18 (Reuters) - The International Monetary Fund raised its growth forecast for Britain's economy this year on Monday ​but ‌warned that further "domestic uncertainty", at a time when political instability is engulfing the government, could hit spending and investment.

In an upgrade that finance minister Rachel Reeves hailed as a sign of progress by embattled Prime Minister Keir ⁠Starmer's government, the IMF said Britain's economy would grow by 1.0% this year.

That was up from a ⁠forecast of 0.8% it made last month when the Fund lowered its ​global outlook to reflect risks from the Iran war. But it would still represent a slowdown for Britain from 2025.

"While the UK economy has remained resilient in recent years, the war in the Middle East is dampening near-term prospects," the IMF said in its annual assessment of Britain's economy.

The new, higher forecast for 2026 was due to pre-war economic momentum which was reflected in recent stronger-than-expected growth and ​revisions to previous ‌data, the Fund said.

NO NEED FOR BOE TO HIKE RATES

Inflation was likely to rise to just under 4% by the end of the year but the BoE would be able to get it back to its 2% target by the end of 2027 without raising interest rates, assuming energy prices fell as markets expect, the report said.

However, given the uncertainty about the Iran conflict, the BoE might have to cut or raise rates and should "be prepared to respond forcefully" if second-round effects - such as worker demands for higher pay or companies raising their selling prices - ​proved stronger than anticipated.

Over the past two weeks, British politics has been rocked by speculation about Starmer's future, driving benchmark 10-year borrowing costs to their highest since 2008 on Friday on the prospect ‌of weaker fiscal discipline.

The IMF warned the turmoil could hit the economy and reinforced the need for the government to stick to its deficit reduction plans which target a balanced budget for non-investment spending by 2029/30.

"Domestic uncertainty could also add to the already volatile global ‌environment, holding back consumption and investment decisions," it said.

Speaking to reporters in London, IMF mission chief Luc Eyraud said markets and investors put a premium on predictable government policy.

"Today's policymaking is constrained by a more volatile external environment with more frequent and overlapping shocks, a rising public interest bill, in part reflecting market concerns with countries' elevated debt, and the long-standing challenge of weak productivity ​growth," he said.

Reeves said the upgrade of Britain's growth forecasts and its support for her budget plans showed Starmer's government had the right plan and she warned potential challengers to the prime minister that they could damage the ‌economy.

"Putting our stability at risk when signs of progress are emerging would leave families and businesses worse off," she said in a statement.

IMF SEES LITTLE SCOPE FOR BROAD COST OF LIVING SUPPORT

Starmer and Reeves are keen to take steps to reduce the cost of living - a major worry for voters - and the Sun newspaper reported over the weekend that Reeves was poised to announce ⁠she would scrap a ⁠rise in fuel tax planned for September.

But the IMF said any energy subsidies should be targeted and temporary, and funded by ‌tax rises or spending cuts rather than new borrowing.

"Staying the course on deficit reduction will be important given market pressures and elevated implementation risks," it said.

Further ahead, the government should consider broadening the base of value-added tax and reforming property ​tax as well as keeping a tighter grip on ​rising welfare spending.

The Fund sounded a note of caution about Reeves' push to streamline financial regulation, saying care needed to be ‌taken to ensure that the cumulative impact of a raft of current and proposed measures did not weaken the financial system.

The IMF's April forecasts represented a 0.5-percentage-point cut from a previous projection for British growth in 2026. That was the biggest cut among Group of Seven nations, due largely to the country's high exposure to international energy prices.

The smaller 0.3-percentage-point downgrade announced on Monday was the same as Germany's downgrade in the April report. (Reporting by David Milliken; Editing by William Schomberg and Emelia Sithole-Matarise)