I was planning to write this week’s edition about the Budget. Ultimately though there wasn’t enough announced by the Chancellor to hit my minimum word count. Luckily, there’s a Bank of England meeting this week that will probably prove more consequential for the economy than anything said in Westminster last week.

UK Budget reaction – what does it mean for the economy?

The Chancellor got through last Wednesday without upsetting financial markets or doing much to actively undermine economic growth. That might sound like a low bar, but it makes this Budget a substantial improvement on some recent ones.

The numbers are small beer, but the Budget still has some important consequences.

The Budget offered households and businesses some modest support through the winter by removing some levies on energy bills and making a £100 payment to households in lower council tax bands. That will add a little over 0.1% to real household incomes next year and shave about 0.1ppts off inflation. But with inflation likely to rise above 4.5% early next year, the Budget measures will be swamped by higher energy prices.

The two big consequences of the Autumn Budget

Two consequences stand out. First, the Chancellor let his headroom against his main fiscal rule fall from around £24bn to £15bn. That wafer-thin margin leaves him vulnerable to any further rise in interest rates or inflation, which seems likely if, as expected, the US attacks Iran again. He could be forced to raise taxes or cut spending sharply in the spring to keep meeting his rule.

Second, the Budget pushed almost all the tough decisions into next year. Current fiscal plans envisage a substantial slowdown in government spending over the next few years, which for many departments outside health and defence will mean sharp real-terms cuts.

What does the Budget mean for next year’s Spending Review?

In next year’s Spending Review, where the Chancellor sets out detailed spending plans, he will either have to commit to the current plans or announce top-ups. Historically, chancellors have opted for top-ups, and this government in particular has made higher public spending a clear priority, so we expect more spending than is currently factored in.

The problem is that meeting the defence spending goal, adjusting budgets for higher inflation and avoiding the real-terms cuts already pencilled in would require spending to rise by £30-40bn. That seems impossible within current borrowing plans and manifesto commitments. So, either the government will have to accept lower spending than it would like, or free itself from the constraints of its manifesto through an early general election. Watch this space…

How high will UK interest rates go?

For most of the time since the Iran crisis began, we had hoped the Bank would be able to keep interest rates on hold this year. However, that no longer looks possible.

Come January, the latest surge in energy prices will push inflation to almost 5%. Inflation above 4% is a tipping point of sorts, where households and businesses start paying much more attention to prices. That makes second-round effects more likely, prolonging the initial surge in prices. Ultimately, inflation above 4% is simply too high for the Bank to sit back and ignore.

Until recently, weakness in the economy, and especially in the labour market, had been enough to offset some of the surge in prices. However, recent data show the economy to be much stronger than expected, and the labour market appears to have turned a corner. That means there’s no longer a trade-off between weak demand and high inflation. The Bank can now raise interest rates to weigh on inflation without worrying about causing a recession.

As a result, a rate hike to 4% on Thursday is almost guaranteed. The big question is how many more will follow.

Strong inflation through the winter means we expect at least one more rate hike next year, with a decent chance of a second. Of course, much depends on how energy prices evolve over the winter, and especially on whether the conflict in Iran escalates again. Either way, interest rates probably won’t start coming back down until 2028.

Tougher times for the UK economy ahead

Overall, the Budget managed not to spook financial markets, but it did little to bring down gilt yields and offered only modest support through what looks set to be a tough winter. Higher interest rates will only add to the drag from rising inflation, so it seems inevitable that growth will slow over the winter. That doesn’t mean next year is a write-off. In fact, we think growth next year will probably be only slightly weaker than this year, but much depends on just how bad this winter gets.

A raft of small cost-of-living measures announced in last week’s Budget should go some way to supporting real household disposable income (RHDI) growth next year.

UK households set for modest real income growth

The measures ranged from a £100 payment for households in council tax bands A-D to a slightly longer fuel duty freeze and an extension of the VAT cut on electricity. None of these measures is particularly large on its own, but updating our forecast to include them leaves the generosity of the welfare state broadly unchanged in 2027, rather than contracting as the previous Chancellor outlined back in the spring.

As a result, we now expect real household disposable incomes to grow by around 0.3% in 2027. That’s barely more than stagnation, but it is an improvement on our pre-Budget forecast. What’s more, the stronger-than-expected labour market, which we documented last week, gives households a little more scope to bid up wages to protect their real incomes. Good news for households, less so for the Bank of England.

All told, households will still come under pressure from higher inflation in the coming months, but the Budget’s cost-of-living measures and some postponed welfare consolidation will support real incomes, and in turn consumer spending, over the coming year.

We expect the final Composite PMI for October to confirm that the economy sustained its solid momentum into Q4, despite higher energy prices dragging on real incomes and squeezing margins.

UK construction activity expected to ease

Elsewhere, the Construction PMI, which doesn’t have a flash release, probably eased back a little from 46.1 to 45.8, as new orders weakened in September and firms’ optimism about the outlook fell to a four-month low, consistent with a further fall in the Construction PMI. That said, October’s survey should fully capture PM Burnham’s ‘your first home’ policy, which may boost sentiment by more than we expect.

All told, we expect the final PMIs to show that the economy continued to expand in October despite weak real income growth. That leaves it on track to eke out a little more growth towards the end of the year, albeit at a more subdued pace than in the first three quarters. We expect growth of 1.5% for 2026 as a whole.

Related insights