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Patrick (00:00)
It's Patrick Coffee and this is the Barclays Brief podcast.

So, the UK budget is fast approaching and conversations with friends, colleagues and clients keep drifting back to what Chancellor John Healey might announce on the 28th of October. But is it all doom and gloom? At the recent Labor Party conference, the Prime Minister struck a pretty optimistic tone, talking about the prospect of a better future and the need for the country to hope again.

So today I want to explore the UK economic backdrop ahead of the budget, what options are actually open to the Chancellor, and is the outlook better than many people think? To discuss all of that, I'm delighted to be joined here in London by Jack, meaning our chief UK economist, a regular on the Barclays Brief podcast and the coauthor of the latest green budget with the Institute for Fiscal Studies, and report.

This very likely to be sitting on the Chancellor's desk as we speak.

Okay, so, Jack, you've just completed one of the most comprehensive reports on the UK economy ahead of the budget. What stood out as the most interesting thing you uncovered in that process?

Jack (01:00)
Well, Patrick, I think the thing that surprised me most was when we brought together, you know, our macro expertise and how we assess the backdrop with the fiscal expertise of the IFS.

Actually, the combination of those two things, which, you know, we're really privileged to be able to have really gave me a challenge to the market narrative that the Chancellor is going to find himself really squeezed on headroom at this budget. And the reason for that was because I think the market has been focused on the increase in interest rates and yields, which absolutely will take away from the Chancellor's capacity to to spend and tighten up the fiscal picture.

But when you kind of marry that with actually what's going on with inflation and nominal tax bases, which is where we could draw on the IFS, you find that actually those two things marry out pretty neutrally. And so the Chancellor may ultimately have headroom. That is broadly where he was back in the spring. And therefore that means that this narrative that he'll have to do quite a lot of fiscal tightening just to keep the show on the road is maybe misplaced. And actually, it could be that he doesn't have to make big changes at this budget just to keep the right side of his fiscal rules.

Patrick (02:14)
Okay. So I can speak on behalf of a lot of people in the country. That's a bit of a relief hearing you say that, Jack, I want to talk about inflation. I want to talk about rates a little bit about growth, and then turn to the options available for Chancellor John Healey thinking about inflation.

My concern is that there are going to be second round effects from the energy price spikes. What's your view on that?

Jack (02:30)
Yeah I mean look, there's unavoidable that we are going to have a near-term inflation peak. The forecast that we and the OBR had had back in the spring, that we would be broadly coming down towards 2%, that is out the window.

It looks like inflation is traveling towards 4%. We think we will probably stop just shy of 4% when we come to January. In the next off gen price cap pushes up prices even further. But ultimately this is happening against the backdrop where there is slack in the labor market. So the unemployment rate has been rising. We're seeing vacancies in the economy drop in, so there's not much price pressure coming through in terms of wage negotiations.

But also firms are telling us they don't see the demand in the economy is strong enough to be able to pass on their input cost increases to more broad prices.

There is really not much evidence yet that this narrow energy shock is passing out into broader prices in the economy. And so we think that the risk of second round effects, it's there.

There will probably be some. But we think the risk of them being anything other than limited is small at the moment.

Patrick (03:42)
Well, that's interesting if you think about how markets are pricing, a pretty aggressive response from the Bank of England to this increase in energy costs and inflation. Do you think there is a scenario where the bank doesn't need to raise rates as much as investors currently expect?

Jack (03:58)
Yeah, the market is expecting four quarter point hikes over the next 12 months. I think if our view of the economy is right and actually the labour market is soft, that growth is going to slow over the next few quarters because of the shock coming from the Middle East, depressing demand. If that's the case, then ultimately inflation won't stay sticky and the bank will maybe only have to increase interest rates once, twice.
Maybe if there's a more protracted conflict going into the start of next year, and therefore that market expectation could be misplaced.

Patrick (04:34)
Okay, so there's another reason for you to be a little bit different to market expectations.
I have to say, when I was reading your note last night, I highlighted the bit where you said the expected neutral interest rate, which for listeners is the bank rate that neither slows nor stimulates the economy, is between 3 to 3.5%.

And as someone remortgaging in a nine months time, that really matters to me.
So let's turn to the budget then. So you started by saying that actually the market narrative might be wrong going into the budget. Clearly the narrative going in is higher yields mean less fiscal headroom. But actually you're talking about higher inflation boosting nominal GDP and tax receipts, which offset some of that pressure.
Talk to me about the dynamic between higher gilt yields and higher inflation.

Jack (05:18)
Yeah. So I mean look let's have some rules of thumb to just give us context. So for every one percentage point that you see bank rate and gilt yields going up, you're probably talking about somewhere like 14 billion pounds off of the kind of the current budget rule.

So that's a squeeze for the Chancellor. But for every one percentage point that you see nominal earnings going up, because people are pulled into higher income tax bands and because there's just a bigger nominal tax base, you're probably talking around about 8 billion pounds back for the Chancellor. So you can broadly say given the guilt yields we've seen come through and given what we expect to see come through in nominal earnings, those two things might broadly balance out.

So the bit that I'm interested in is why is the market missing that I think markets are always prone to focusing on the things that are in front of them in terms of the market. And I think this combination of the kind of the cash story is kind of slightly past people by or at least the extent of it has maybe passed people by, but it also isn't a panacea.
So when you think about that, higher inflation increases nominal earnings. So it brings in that extra money. It's also eroding the budgets of government departments that are set in cash terms. And that's going to create a problem for the Chancellor further down the road.

Patrick (06:40)
We'll hear more about that next year with the spending review.

Jack (06:44)
Right, exactly. He'll have to make a decision, and the chance will have to decide whether to let those budgets stay fixed in cash terms as they've been.
Which means that in real terms, government spending is taking a bit of a hit, or whether he'll have to supplement them to try and offset some of this inflationary shot.

Patrick (06:57)

So is what you're saying here, then, that the really tough decisions around spending will be taken next year? But if you're the Chancellor sitting in 11 Downing Street at the moment with your red briefcase next to your desk, there is a way where the Chancellor doesn't do much that's that dramatic and delivers a largely, to quote George Osborne from a while ago, a steady as she goes budget.

Do you think, if that's the case that businesses and markets will react positively?

Jack (07:22)
Yeah, I think so. I think the Chancellor delivering something that seems sensible continuity will be beneficial.
Now that's true in markets. I think markets will be looking at the UK as one of the less volatile kind of debt markets. I think it's true if you kind of go beyond debt markets into FX as well, but also it's true in the real economy. So we've surveyed recently a whole range of UK businesses and corporates, and eight out of ten of those told us that if the Chancellor can deliver something that is instilling confidence in the outlook, then they would increase their investment.
And that's on top of plans to already increase investment over the coming year. This would just amplify and provide the confidence and certainty that businesses need. So yeah, steady as she goes. I think Patrick is the watchword.

Patrick (08:19)
What about capital gains tax? That's something that lots of people are talking about. Do you expect to rise there?

Jack (08:30)
The difficulty with capital gains that the Chancellor faces is depending exactly how it's calibrated and designed, it probably won't raise very much money.
And if it does, it will change incentives around the economy and potentially be distortions in a way that the Chancellor may not want over the longer term. So there are cases that can be made for equalizing the taxation that you do via wealth and profit versus those that you have on labor. That's an open discussion. But fundamentally, if what you're thinking about is trying to raise revenue in the future, capital gains seems like a pretty difficult one to to pull the lever on.
And it will also be a hard one for businesses to digest that the looking for that steady as she goes.

Patrick (09:10)
Okay. So we've got all these near-term challenges with inflation concerns, interest rate concerns. I guess one of the most encouraging parts of the report was around business investment. And I scribbled a couple of numbers down. So between 2015 to 2025, UK business investment grew on average around 0.6% quarter on quarter.

But for the first half of 2026, it averaged roughly 2.4%. That's a big step up when you look under the surface. A lot of that came from ICT related investment. So am I extrapolating too much that actually below the surface we're seeing a bit of an AI boom that's being missed in the UK?

Jack (09:45)
No, I think there are nascent signs of that coming through actually in the UK.

So as you say, a large part of the growth that we saw in the first half of the year was coming from not just AI, but AI adjacent being. So there's part of it, which is data centers as part of it, which is people investing in the decision to kind of skill up within their workforce and those type of things that are beneficial for long term productivity and long term growth.

I guess question now is how much does that continue and how much does it spread over more widely into the economy? So we ran a scenario in a report where we showed that if this is just a narrow, AI focused investment boom, maybe akin to some of what you've seen in the US that will have a near term growth impact, it will boost demand, but it doesn't lead to a prolonged and sustainable impact on growth unless it spreads over into total factor productivity and starts percolating through the economy more widely.

And so really, that's what we need to see, is it's not just the investment boom, it's the associated increase in productivity more widely.

Patrick (10:40)
But if that spillover effect of percolating, as you call it, does happen, that could be the UK's kind of best route out of this low growth, high, high tax environment, right.

Jack (11:00)
Absolutely. Productivity growth is the secret sauce that really drives, you know, improve standards of living. It helps boost tax revenues, boost growth per person.

Patrick (11:08)
Okay. So let's just wrap this up by thinking about the UK in the broader European context. There's investors. Look at Europe right now. They see challenges everywhere right.

So concerns around France's fiscal position Germany struggling with some pretty tough budget choices. Political uncertainty in parts of southern Europe. You know we've got the Spanish snap election coming up. And against that backdrop, the UK is starting to look relatively stable, isn't it?

Jack (11:34)
Yeah I mean, look, we've had our moments. Let's be clear over the last few years, 2022 is not that long ago and lives long in the memory of the market, I think. But I'm an economist. Let's look at the data and the numbers. The UK's deficit is broadly in the middle of the pack.

We're not an outlier in terms of how much we're borrowing. Our debt to GDP is broadly again in the middle of the pack. We're not an outlier. We now have a Chancellor who is continuing to be committed to a consolidation to improve that fiscal outlook. That may be difficult to do, but everything we hear is that that is staying on track.

And it's a Chancellor with a large majority behind him and a fixed kind of term of the parliament, unless they choose to call an early election. But let's assume they run the next three years without one. That is a base for stability.

So, if the Chancellor can deliver that again at this budget, then, as you say, against the backdrop of a French economy that is looking very volatile, other European peers looking volatile, a US political situation running into the midterms, actually, the UK could be that island of stability that many in the market are looking for.

Patrick (12:43)
Island of stability. Well Jack, if they do call in an early election, we'll have you back up here very quickly to talk about it. But otherwise, thanks a lot for joining. Absolute pleasure. So I have to admit, when I invited Jack up here to talk about the budget, I was pretty nervous. But I think I'm finishing this conversation walking out of the room a bit more optimistic.

Clearly, there are reasons to be cautious on the UK in the next 3 to 4 quarters, and the Chancellor needs to maintain fiscal credibility while supporting growth. But there is some room for manoeuvre and some scope for optimism. Investments holding up productivity may finally be improving and compared with some of its European peers, the UK's position actually looks relatively stable.

So let's see what happens at the UK budget on the 28th of October. Thanks a lot for listening to the Barclays brief. We'll be back again next week and do hit subscribe if you enjoyed this conversation.