Image source, Dan Kitwood/Getty ImagesByDharshini David, Deputy economics editor and Tom Espiner, Business reporter- Published33 minutes ago
The price spike caused by the US-Israel war in Iran poses a major challenge for Chancellor John Healey as he puts together his first Budget, an influential think tank has warned.
Higher-than-expected inflation could eat into what the government hoped to spend on public services, meaning Healey will have to choose between spending cuts, tax rises, or a mixture of both, the Institute for Fiscal Studies (IFS) said.
It urged the government to ensure its spending plans are credible, as opposed to proposing unrealistic future cuts to make the Budget add up.
The Treasury declined to comment on "rumour and speculation".
However, speaking ahead of the annual International Monetary Fund meeting this week, 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".
However, the government is under growing pressure to show financial markets that it has a tight grip on finances as the cost of borrowing rises.
The IFS cautioned Healey about making any spending announcements in the 28 October Budget speech 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 said.
"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.
The US-Israel war against Iran and Russia's invasion of Ukraine have together helped drive up energy prices around the world.
These higher costs have been passed to customers via higher prices on shelves and at the pumps.
The wars have also contributed to a rise in the cost of UK government debt interest payments, adding to the pressure on Healey.
Although higher inflation will boost tax revenues, it will also eat into the value of departments' cash budgets, the IFS said.
'Breathing space'
Like other analysts, the IFS thinks recent turbulence on bond markets and higher inflation will add around £10bn to forecasts for the government's borrowing costs in 2029-30.
However, it still expects the government to meet its self-imposed fiscal rules - that it will only borrow for investment projects by the financial year 2029-30 and also be reducing debt as a percentage of GDP - not least as inflation pushes up tax revenues.
But it expects those rules to be met by a smaller buffer - known as "headroom" - of around £20bn. That is less than the £24bn buffer predicted at the time of the Spring Statement by the official forecaster, the Office for Budget Responsibility (OBR).
Recent indications have been that the markets would be comfortable with that degree of reduced headroom. The IFS also expects any "breathing space" help for households to be temporary and limited in scale.
However, the IFS warns that in such a volatile environment, its forecasts are exceptionally uncertain. And the official forecast from the OBR - which the chancellor relies on when making his plans - may come to a very different conclusion.
The IFS reckons that to maintain departments' budgets in the face of higher inflation, the government may need to find an extra £25bn in 2029-30.
That is before consider considering the ambition to raise defence spending. Raising such an amount would point to significant tax rises.
The chancellor does not have to address spending totals in this Budget, and may choose to leave such decisions until future events - for example, next year's Spring Statement or Spending Review - by which time the outlook for the economy could look very different.
But the IFS warned that the spending plans inherited from the previous chancellor, Rachel Reeves, would mean some departments' budgets would not keep pace with inflation in a few years time.
It said not addressing this would cast doubt on the credibility of the government's plans.
However, previous chancellors have relied on a similar strategy of pencilling in unrealistic future spending plans to ensure that they meet the fiscal rules on the day - only to change the plans further down the line.
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