A leading think tank has warned that the price spike caused by the US-Israel war in Iran poses a serious problem for Chancellor John Healey as he assembles his first Budget.
According to the Institute for Fiscal Studies (IFS), inflation running hotter than expected could shrink the sums the government had hoped to direct towards public services. That would leave Healey choosing between cutting spending, raising taxes, or combining the two.
The IFS pressed the government to make its spending plans credible, arguing that pencilling in future cuts it does not intend to carry out to make the numbers add up is not a real solution.
The Treasury declined to comment on “rumour and speculation”.
Speaking ahead of this week’s annual International Monetary Fund meeting, Healey said: “The consequences of conflict in the Middle East and Europe are hitting countries worldwide, leading to higher prices at the pumps and more expensive mortgages at home.
“But Britain and our allies can face up to these challenges together.”
He said his Budget “will build on this approach with fiscal discipline helping to deliver economic resilience” and give people “breathing space”.
But as the cost of borrowing rises, the government is under growing pressure to prove to financial markets that it holds a tight grip on the public finances.
The IFS warned Healey against making spending announcements in his 28 October Budget speech that he has no intention of honouring.
“A ‘steady-as-she-goes’ Budget is not an option available to the chancellor,” said IFS director Helen Miller.
“Choosing to stay the course with the inherited tax and spending plans would mean allowing inflation to blow departments’ spending plans off course.
“Simply pencilling in implicit cuts that he has no intention of delivering would make the Budget a work of fiction,” she added.
Two conflicts — the US-Israel war against Iran and Russia’s invasion of Ukraine — have together helped push energy prices up around the world. Those higher costs have reached customers through shelf prices and at the pumps.
The wars have also helped drive up the cost of servicing UK government debt, piling further pressure on Healey.
The IFS noted that while higher inflation lifts tax revenues, it simultaneously erodes the real value of departments’ cash budgets.
Like other analysts, the IFS believes recent turbulence on bond markets and elevated inflation will add roughly £10bn to forecasts for the government’s borrowing costs in 2029-30.
Even so, the IFS still expects the government to satisfy its self-imposed fiscal rules — borrowing only for investment projects by the financial year 2029-30, and reducing debt as a share of GDP — helped in part by inflation raising tax revenues.
It expects those rules to be met, however, with a smaller buffer, known as “headroom”, of about £20bn. That is below the £24bn buffer the official forecaster, the Office for Budget Responsibility (OBR), projected at the time of the Spring Statement.
Recent signals have suggested markets would tolerate that degree of reduced headroom. The IFS also expects any “breathing space” offered to households to be short-lived and modest in size.
In such a volatile environment, the IFS cautions that its forecasts are unusually uncertain, and that the official OBR forecast — the one the chancellor relies on when drawing up his plans — could reach a very different conclusion.
The IFS calculates that keeping departments’ budgets intact in the face of higher inflation may require the government to find an additional £25bn in 2029-30.
That figure comes before any consideration of the ambition to raise defence spending, and finding such a sum would imply significant tax rises.
The chancellor is not obliged to settle spending totals in this Budget. He may instead defer such decisions to future events — next year’s Spring Statement or Spending Review, for instance — by which point the economic outlook could look very different.
The IFS warned, however, that the spending plans inherited from the previous chancellor, Rachel Reeves, would leave some departments’ budgets failing to keep pace with inflation within a few years.
Failing to address that would raise questions about the credibility of the government’s plans, the IFS said.
Earlier chancellors have leaned on a similar tactic — writing in unrealistic future spending plans to satisfy the fiscal rules on the day — only to revise those plans later.
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