Heading for Groundhog Day in the October Budget

The Chancellor has made herself a prisoner of her own self-imposed fiscal rules and now she is a hostage to fortune.

Today’s spring statement saw the independent forecaster, the Office for Budget Responsibility (OBR), confirm that the economy had stagnated in the second half of last year and it halved its growth forecast to 1% for 2025. A combination of factors contributed to this, including weak productivity, the hit to confidence ahead of last October’s Budget and the increase in taxes announced within it, plus the far more uncertain external climate with gas prices in 2025 expected to be 30% higher than previously expected.

In turn, this meant that the Chancellor’s fiscal rules from last October would have been broken, forcing her to announce a series of fiscal measures today to meet them. These measures covered a range of areas including curbing the growth in welfare spending, to bring the fiscal headroom almost back to where it was last autumn.

This fiscal fine-tuning suggests a back-to-front approach, where policy is being driven to meet these rules. However, even after doing so, the new fiscal headroom remains small and thus even a slight deterioration in economic prospects will leave the Chancellor having to revise her plans again.

Such a change to fiscal plans is very likely, as an optimistic growth outlook has been factored into the latest plans. For even though the OBR has cut its growth forecast for this year, it expects the economy to rebound in future years.

Yet despite all today’s fiscal fine-tuning to get the fiscal headroom back to where it was, and despite the optimistic forecasts for a future rebound in growth, the future profile for debt outlined today is slightly worse than the OBR forecast last autumn. Debt levels are expected to remain high. This is not good. A more difficult – or perhaps one might say, more realistic – economic outlook would see the Chancellor soon breaching her fiscal rules again. This could happen as early as the Budget this October, with further pressure to then curb spending, raise taxes and borrow more.

Let’s look at the growth and debt numbers.

Last autumn the Chancellor announced that she was moving to only one fiscal event a year. However, the OBR is obliged by Parliament to provide a new forecast at this time of year. In turn, because of the impact of new economic and fiscal forecasts the spring statement had many of the hallmarks of a mini-Budget - indeed Table 3.1 of the Treasury document pointed to 31 policy changes.

First, the OBR revised down its growth forecast for last year from 1.1% to 0.9%. Also, it noted that, “the measured level of productivity (output per hour worked) at the end of 2024 was 1.3 per cent lower than in the October forecast.” For this year, the OBR cut its growth forecast from 2% to 1%, noting that one-third of this reduction was due to “structural weakness” linked to low productivity and two-thirds because of cyclical factors, which it largely expects to be reversed next year with lower gas prices and lower interest rates, allowing slack in the economy to be then used up.

As a result, it expects growth of 1.9% in 2026 and around 1.75% over the remainder of the decade, as the workforce rises. The economic consensus sees growth of 1% this year also, and 1.3% next. It is through the OBR’s projection for future productivity that leaves it optimistic relative to the consensus.

Two positives factored into the forecasts were the impact of higher defence and increased housebuilding, largely because of the welcome easing in planning reform. These make sense. However, the OBR did not factor in any impact from the imminent Employment Rights Bill, but all the signalling from firms, particularly SMEs (Small and Medium-sized Enterprises), is that this impact will be negative, alongside the imminent increase in national insurance.

Sensibly, the OBR was keen to stress that, “Significant uncertainty surrounds domestic and global economic developments.” In particular it noted that, “If the projected recovery in UK productivity growth fails to materialise, and it continues to track its recent trend, then output would be 3.2 per cent lower and the current budget would be 1.4 per cent of GDP in deficit by the end of the decade.” The external environment on trade and defence adds to uncertainty, although the UK would clearly benefit if geopolitics allowed gas prices to fall.

The OBR also expects higher inflation this year. Last October the OBR saw inflation at 2.6% this year and has revised this higher to 3.2% before it expects inflation to fall sharply towards the 2% target in future years. One consequence of all this is that, perhaps surprisingly, the OBR now expects the size of the economy (in nominal terms, so taking into account inflation and growth) to be slightly higher at the end of this decade than it previously thought. In 2029 the size of the economy was expected to be £3,367 billion. This is now expected to be £3,433 billion.

Given the size of the economy, the fiscal headroom is tiny.

The Chancellor has a main fiscal rule to not borrow for current consumption and so to have the current budget in surplus by 2029/30, and two supplementary ones, one on debt and another to control welfare spending. Savings from welfare reforms, a reduction in day-to-day departmental spending, and the indirect boost to receipts from planning reforms are projected to raise £14.0 billion in 2029-30, offsetting the underlying deterioration in the fiscal numbers, allowing her rules to be met by small margins in 2029/30.

In October the headroom on her current budget was £9.9 billion, or only 0.3% of GDP. As the Chancellor was set to miss this by £4.1 billion, she curbed spending today, to get the headroom back to exactly £9.9 billion. The fiscal rule for debt is to have public sector net financial liabilities falling as a share of GDP.

The headroom on this debt measure was £15.7 billion last October and is now £15.1 billion, or 0.4% of GDP. There is naturally a large margin of error linked to these forecasts. Thus the rules could easily not be met, with the OBR predicting there is now a 54% probability of meeting the current surplus fiscal rule and a 51% chance of achieving the Public Sector Net Financial Liabilities (PSNFL) rule. This doesn’t leave much room for manoeuvre. 

The debt outlook is a worry.

The budget deficit is expected to fall from 4.8% of GDP in 2024/25 to 2.1% in 2029/30, with public sector net borrowing peaking at £137.3 billion in 2024/25 before reaching £74.0 billion in 2029/30. In October this latter figure was expected to be £70.6 billion. Public sector net debt (PSND) remains high, but largely flat, at 95.9% of GDP this year and 96.1% in 2029/30.

To repeat a previous message, when debt is so high, it remains vulnerable to weaker growth or higher interest rates. This summer’s comprehensive spending review will see a real terms increase in annual expenditure. Apart from inflating the debt away, the government has a combination of five options: growth, reform, austerity, tax or borrow. Growth may be weaker, reform may take longer and thus the focus in the October Budget may turn to a combination of austerity, tax and borrow.

Please note, the value of your investments can go down as well as up.