Rising inflation will reduce Chancellor’s borrowing windfall from rapid pandemic recovery


The UK is set for its biggest ever current-year economic growth upgrade next week as a result of a smaller-than-forecast pandemic hit, and a faster-than-expected pandemic recovery, but rising inflation will squeeze both the Chancellor’s borrowing windfall and family budgets this autumn, according to new research published today (Tuesday) by the Resolution Foundation.

The Uncertainty Principle examines the UK’s economic and fiscal outlook and what this means for the big policy decisions facing the Chancellor as he prepares to deliver his Budget and Spending Review next Wednesday.

The report notes that the combination of data revisions that have reduced the size of the pandemic hit, along with a faster-than-expected pandemic recovery this year, will mean the biggest ever upgrade to current year GDP forecasts in nearly 40 years of fiscal projections.

The economy is set to grow by 7.5 per cent in 2021 – the fastest peace-time annual growth in nearly a century, following the largest contraction in a century in 2020.

However, this bumper recent past will be tempered by a less than rosy present and future, with recent data suggesting that the UK’s economic recovery has slowed (GDP rose by just 0.3 per cent in July and August) while inflation has picked up.

The report notes that estimates of the annual improvement in borrowing this year are centred around £25 billion, but are unusually uncertain. This is smaller than many are assuming due to an expected record rise in the inflation forecast.

Looking ahead to the middle of the decade, the report notes that borrowing is set to be around £10 billion lower. The improvement in borrowing by the middle of the decade is dependent on the OBR reducing its estimate of the longer-term impact of the pandemic from 3 to 2 per cent.

Inflation, which has risen from 0.4 per cent in February to 3.2 per cent in August, is set to hit 4 per cent over the winter, is also set to reduce household incomes by £1,000 next year (relative to the OBR’s forecast last March for inflation to fall through 2021).

The Foundation notes that this updated economic outlook should enable the Chancellor to meet his new fiscal rules of closing the deficit for day-to-spending and seeing debt fall as a share of the economy.

However, it warns that the Chancellor may have little fiscal wiggle room against these targets which, when combined with the hugely uncertain economic outlook over the coming years, means the Chancellor should not assume easy fiscal choices lie ahead over the remainder of the parliament.

The Uncertainty Principle says that the Chancellor faces a number of other tough choices for his Budget and Spending Review, including:

  • Cost of living crunch – introducing new policies to relieve the pressure on family finances stemming from rising energy bills, the £20 a week cut to Universal Credit, and a renewed pay squeeze over the winter if inflation overtakes pay growth.
  • Post-austerity – funding for public services outside of health, defence, education and overseas development (which together account for 60 per cent of all day-to-day spending) are set to be a fifth lower by the middle of the decade than they were in 2009-10, with only a third of cuts announced since then having been reversed.
  • Net Zero vs Levelling Up – the Chancellor faces competing priorities allocating the remaining two-thirds of the Government’s large capital spending budget, from demonstrating the Government’s green credentials ahead of COP26 next week, to tackling regional inequalities and raising productivity.

James Smith, Research Director at the Resolution Foundation, said:

“Following a regular whirlwind of fiscal announcements in just 18 months as Chancellor, next week Rishi Sunak will finally get to deliver a Budget and Spending Review aiming to set a course for post-Covid Britain. But that doesn’t mean the choices he’ll face will be easy.

“The backdrop to the Budget will be a strong recovery from the pandemic that risks being derailed by rising inflation and economic disruption that will squeeze both the Chancellor’s borrowing windfall and family budgets.

“The decisions the Rishi Sunak will take next Wednesday will help to define the rest of the parliament, and the type of Chancellor he’ll be remembered as. But amid such long-term and legacy-defining announcements, he must not forget the cost of living crunch facing families up and down the country right now.”