What Britain must do in a new, riskier phase for the economy

The following column by Gerard Lyons appeared in The Telegraph on Sunday 29 December, 2025. Gerard shares his insights on how lower inflation and interest rates will offer some comfort amid economic risks and states that the UK must focus on public spending and back business.

What lies ahead in 2026? To judge the UK’s prospects, start with the global backdrop. This points to modest growth and low inflation, with intensifying competition in export markets. Expect greater uncertainty in policy as global debt levels remain high. Geopolitical tensions and potential financial market volatility will add to risks.

There will be a familiarity at the start of the year, as the themes that dominated in 2025 remain centre stage. Notably, US policy unpredictability persists, leading to contagion elsewhere. The legacy of tariff policy will be felt, with sticky US inflation and trade disruption. The rules-based global system will come under further strain.

Geopolitical issues will persist. These have disrupted global supply chains as globalisation has given way to fragmentation. More countries have become protectionist, adopting a home-country bias. The UK has responded with its new industrial policy. National security and economic policymaking are becoming increasingly indivisible, alongside increased defence spending across western Europe.

On the IMF’s numbers, global growth is projected to be broadly stable, at 3.1 per cent in 2026 versus 3.2 per cent in 2025. This reflects a welcome degree of resilience, but it is still a significant change from the 4.5 per cent-plus that we witnessed before the 2008 global financial crisis.

With the US and China accounting for such a large share of global growth, attention will remain fixed on both. Each faces hurdles, including deflationary pressure and weak domestic demand in China and a stretched fiscal position in the US, but both will pull policy levers and grow steadily. China will ease fiscal policy as well as unveil a new five-year plan; the US will cut rates if needed. In turn, the dollar may continue to weaken from passive diversification, as investors allocate fewer new assets to the US, as opposed to actively selling existing holdings.

These forces represent a shift to a riskier phase of the global economic cycle. Against this backdrop, two worries stand out: one fiscal, the other financial.

Globally, public and private debt levels are close to all-time highs. This leaves government bond markets more exposed to shifts in sentiment. France provided a recent timely warning, as markets balked at stalled pension reform. Expect more focus globally during 2026 on the relationship between growth and interest rates: the
“g-r” spread. This is key for fiscal debt dynamics, with weak growth and high debt servicing costs being the concern.

The financial worry is what is happening in the shadows, and whether it is as scary as we might fear. Since the 2008 financial crisis, more business has gravitated away from the regulatory glare and into the financial shadows.

The Financial Stability Board recently published its annual assessment of so-called shadow banks. The scale of these non-bank financial institutions (NBFIs) is hard to ignore. They account for $257 trillion, or 51 per cent of global financial assets and are larger than the banking system. The banks, by contrast, have become safer, carrying more capital. One positive in western economies in 2026 is whether this encourages a healthier appetite for lending.

As the non-bank sector is complex and the data takes time to compile, the release is new but the figures relate to 2024. In that year shadow bank assets grew 9.4 per cent, double that of banks. Over the last year, buoyant markets and low rates may have seen it grow further.

Non-bank institutions are a broad bucket, including pension funds and insurance companies, but on the riskier “narrow measure” that captures leveraged activity, they account for a sizeable $76.3 trillion. That’s almost three quarters of the size of the world economy.

This matters because it relies on short-term funding and may be susceptible to runs and sudden liquidity gaps. It is also why the Bank for International Settlements has raised concerns about leveraged shadow banking activity in government bond markets at a time of rising public debt. If global financial conditions tightened abruptly, the contagion risk could be high. For now, US rates are heading lower, but 2026 will be the year policy rates bottom and more countries start to tighten, too.

It reinforces the need for the UK to become competitive and to ensure domestic demand is resilient, both of which have proved challenging over the last year. In particular, we need to reduce energy costs while not sacrificing the green agenda.

We also need to be mindful of contagion if the focus of global investors shifts towards debt. This should focus policy on keeping public spending under control. The UK is already carrying a high-risk premium on gilt yields because of fiscal worries and sticky inflation.

A positive though is that inflation should fall significantly towards its 2 per cent target. Intense global competition including a wave of competitively priced, high-quality exports from China into Britain and Europe could help dampen price rises. Also, service sector price pressures should moderate and from April the inflation picture will be improved by lower household energy bills, plus freezes in fuel duty and rail fares.

This should allow the Bank of England to cut rates from 3.75 per cent now to 3.5 per cent by the spring. That may be seen as neutral. Nonetheless, the improved inflation outlook should allow scope for bank rate to decline to 3 per cent in 2026 if the economy weakens.

Unemployment has risen from 4.1 per cent at the time of the general election, to 5.1 per cent. Recent policy measures such as the contentious Employment Rights Bill are adding to business costs and will weigh on jobs and the economy.

Lower inflation should boost real incomes. The savings rate is high and corporate balance sheets appear sound, which should help sustain spending. Modest UK growth, in line with the 1.4 per cent official projection, is possible.

The key message is that there is no other answer than growth if the UK is to boost living standards, protect its national security and best insulate itself from global uncertainty.

This article is for informational purposes only and does not constitute financial advice.