UK economy growth forecasts lowered from next year

UK economy growth forecasts lowered from next year

The Office for Budget Responsibility (OBR), the UK's independent fiscal watchdog, has lowered its economic growth forecasts for the United Kingdom. In its assessment accompanying the Chancellor's Budget, the OBR now expects the economy to grow at an average annual rate of 1.5% over the next five years, a downward revision from previous estimates. This more pessimistic outlook creates a challenging fiscal environment for the government's spending and taxation plans.

Context & What Changed

The United Kingdom's biannual budget process is anchored by independent economic and fiscal forecasts from the Office for Budget Responsibility (OBR), established in 2010 to provide impartial analysis of the public finances (source: obr.uk). The Chancellor's policy decisions are made against the backdrop of these forecasts, which determine the projected tax revenues and the 'fiscal headroom' available under the government's self-imposed fiscal rules—typically concerning the trajectory of public debt and the deficit. The key change announced alongside Chancellor Rachel Reeves's Budget is a material downgrade of the OBR's medium-term GDP growth forecast. The OBR now projects the UK economy will grow at an average annual rate of just 1.5% over the five-year forecast period (source: bbc.com). This revision reflects a confluence of persistent domestic and global headwinds, including stubborn inflation which has eroded real incomes, the lagged effect of higher interest rates implemented by the Bank of England to combat that inflation, and chronically weak productivity growth, a long-standing challenge for the UK economy (source: ons.gov.uk). This downgrade is significant because it directly reduces projected tax receipts, thereby shrinking the government's available resources and severely constraining its ability to fund new spending initiatives or implement significant tax cuts without increasing borrowing or breaking its fiscal rules.

Stakeholders

UK Government (HM Treasury): The primary stakeholder, facing diminished fiscal headroom. The Chancellor must navigate difficult trade-offs between manifesto commitments, demands for public service funding, and maintaining fiscal credibility with international markets. The downgrade forces a choice between spending restraint, targeted tax increases, or adjusting fiscal rules.

Office for Budget Responsibility (OBR): As the independent forecaster, its credibility is paramount. The downgrade underscores its role in holding the government to account on the sustainability of its plans and grounding policy in a realistic economic assessment.

Bank of England: The Monetary Policy Committee's decisions are influenced by growth and inflation forecasts. Slower growth could argue for earlier interest rate cuts to stimulate the economy, but this is complicated if inflation remains above the 2% target. The OBR's assessment of slack in the economy will be a key input.

Investors (Gilt & Equity Markets): Domestic and international investors will scrutinize the government's response. The credibility of the fiscal plan is critical for the stability of the UK government bond (gilt) market and the value of sterling. A perceived lack of fiscal discipline could trigger market volatility, as seen in the autumn of 2022 (source: ft.com).

UK Businesses & Industry: Lower growth forecasts translate into weaker consumer demand and a more challenging investment climate. Sectors reliant on government contracts (e.g., construction, defence, outsourcing) face uncertainty over future spending. Corporate investment decisions will be deferred or scaled back amid heightened economic uncertainty.

Public Sector & Infrastructure Bodies: Government departments, local authorities, and agencies like Network Rail and National Highways face the prospect of tighter budgets. This puts pressure on service delivery and could lead to the re-phasing, scaling back, or cancellation of major capital infrastructure projects outlined in the National Infrastructure Pipeline.

Households: The forecast implies slower growth in real wages and employment opportunities. It also signals a period of constrained public spending, which could affect the quality and availability of public services, alongside the potential for a higher tax burden over the medium term.

Evidence & Data

The central piece of evidence is the OBR's revised forecast of 1.5% average annual GDP growth over the next five years (source: bbc.com). This compares unfavorably with the long-run average UK growth rate of around 2.5% in the decades before the 2008 financial crisis (source: Bank of England). The downgrade is underpinned by several component forecasts:

Productivity: UK productivity growth has been weak for over a decade, lagging major competitors like the US, Germany, and France. The OBR's forecast assumes this trend will not significantly reverse in the medium term (source: ons.gov.uk).

Business Investment: Has remained subdued since the 2016 Brexit referendum and has been further impacted by global uncertainty and higher borrowing costs. It remains below its pre-pandemic peak in real terms (source: ons.gov.uk).

Public Debt: The UK's public sector net debt stands at approximately 98% of GDP (source: ons.gov.uk), a historically high level. The slower growth path makes reducing this ratio more difficult, as the denominator (GDP) grows more slowly. Each percentage point of lost nominal growth adds billions to the debt-to-GDP ratio over time.

Fiscal Impact: A 1 percentage point reduction in the level of real GDP can, as a rule of thumb, worsen the public finances by approximately £15-20 billion per year through lower tax revenues and higher welfare spending (author's assumption based on OBR sensitivity analysis).

Scenarios (3)

Scenario 1: Fiscal Prudence & Stagnation (65% Probability): The government prioritizes adherence to its fiscal rules to maintain market credibility. This leads to a combination of stealth taxes (e.g., freezing tax thresholds), efficiency savings across public services, and a re-profiling of major infrastructure projects, delaying non-critical spending. Economic growth hovers around the OBR's 1.5% forecast. The Bank of England enacts slow, cautious interest rate cuts. This path avoids a market crisis but delivers a prolonged period of low growth and strained public services, posing significant political challenges.

Scenario 2: Austerity 2.0 (20% Probability): A further negative shock to the global economy or a loss of market confidence forces the government into a more aggressive fiscal consolidation. This would involve explicit, deep cuts to departmental budgets (excluding protected areas like health), a freeze on public sector hiring, and potentially a rise in a major tax like VAT or National Insurance. This could trigger a short, shallow recession but would aim to rapidly reduce borrowing and reassure bond markets, potentially leading to lower long-term interest rates.

Scenario 3: Unfunded Dash for Growth (15% Probability): Facing political pressure and a potential election, the government rejects the OBR's constraints and announces significant unfunded tax cuts or spending increases, hoping to stimulate a higher growth trajectory. This strategy breaks with fiscal orthodoxy and risks a severe negative reaction from financial markets, leading to a spike in government borrowing costs, a sharp fall in sterling, and an inflation surge—a repeat of the 2022 'mini-budget' crisis. This is a high-risk, low-probability scenario given the recent historical precedent.

Timelines

Immediate (0-3 Months): Financial markets will digest the full details of the Budget and the OBR report. Sterling and gilt yields will adjust to the new fiscal path. Businesses will begin revising their 2026 budgets and investment plans.

Short-Term (3-12 Months): Initial policy measures from the Budget take effect. Government departments will receive their updated spending envelopes and begin planning for a tighter fiscal environment. The impact on consumer and business confidence surveys will become apparent.

Medium-Term (1-3 Years): The main impact of the fiscal consolidation or stimulus measures will be felt in the real economy. The actual GDP growth path will be tracked against the OBR's forecast, with significant deviations influencing future Bank of England policy and the government's fiscal stance. Infrastructure projects identified for delay will see work slow down or stop.

Long-Term (3-5+ Years): The cumulative effect on the UK's debt-to-GDP ratio and potential growth rate becomes clear. The success or failure of the chosen economic strategy will be evident, forming the central economic debate at the subsequent general election.

Quantified Ranges

GDP Growth: The central forecast is a 1.5% average annual rate. Across the scenarios, this could plausibly range from a low of 0.5% (in an Austerity 2.0 scenario) to a high of 1.8% (if productivity-enhancing reforms outperform expectations in the Fiscal Prudence scenario).

Public Sector Net Borrowing (PSNB): The lower growth forecast, absent policy changes, would likely increase borrowing by £15-25 billion annually by the end of the forecast period compared to previous projections (author's estimate).

Infrastructure Investment: Public sector gross investment is a key discretionary spending lever. Projects within the £700-775 billion National Infrastructure and Construction Pipeline could be subject to review (source: gov.uk). A re-phasing or cancellation of 2-3% of this pipeline would represent a £14-23 billion cut to future investment.

Risks & Mitigations

Risk: Loss of Market Credibility: An unfunded spending or tax-cutting package could trigger a gilt market crisis. Mitigation: The government must ensure all policy decisions are fully costed by the OBR and accompanied by a clear, credible plan for fiscal sustainability. Transparent communication from the Chancellor and HM Treasury is essential.

Risk: Deeper-Than-Forecast Economic Slowdown: Global shocks (e.g., energy price spikes, geopolitical conflict) or higher-for-longer interest rates could push the UK into recession. Mitigation: Maintain fiscal buffers where possible. The Bank of England can provide monetary stimulus, but its ability is constrained by inflation. The government's role is to ensure financial stability and provide targeted support.

Risk: Failure to Boost Productivity: The central long-term risk. If productivity growth remains stagnant, the UK is locked into a low-growth, high-tax future. Mitigation: Implement a consistent, long-term strategy of supply-side reforms focusing on planning system liberalization, skills and technical education, and incentives for business investment and R&D.

Risk: Political Backlash: Spending cuts and tax rises are politically unpopular and can lead to policy instability. Mitigation: Frame decisions within a clear narrative about long-term fiscal health. Protect funding for core, visible public services where possible and seek efficiencies in back-office and administrative functions first.

Sector/Region Impacts

Construction & Infrastructure: Highly exposed to cuts in public capital spending. Firms reliant on large, state-funded projects (e.g., transport, energy, social infrastructure) face significant revenue risk from project delays or cancellations.

Public Services (Health, Education, Local Government): Will face intense pressure to deliver more with less. Real-terms budget cuts per capita are likely, impacting service quality, waiting times, and public sector morale.

Retail & Hospitality: Slower wage growth and low consumer confidence will continue to depress discretionary spending, impacting a sector already dealing with high energy and labor costs.

Financial Services: While a stable fiscal policy is a net positive, a low-growth environment limits credit growth and can increase loan-loss provisions for banks. Asset managers will face a less attractive domestic equity market.

Regional Policy: The 'Levelling Up' agenda, which relies heavily on public investment in regional infrastructure and R&D, is at significant risk. A constrained fiscal environment may force a retreat to funding only the highest-value projects, potentially exacerbating regional inequalities.

Recommendations & Outlook

For Government & Public Agencies: The overriding priority must be to maintain fiscal credibility. (Scenario-based assumption: The government will pursue the 'Fiscal Prudence & Stagnation' path as the most politically and economically viable). Focus must shift from large-scale spending announcements to high-impact, low-cost supply-side reforms. A radical overhaul of the UK's planning system to accelerate infrastructure and housing delivery would be the single most effective policy for boosting long-term growth. Public bodies must prepare for a multi-year period of flat or declining real-terms budgets and prioritize ruthless efficiency.

For Infrastructure & Large-Cap Industry Actors: Stress-test business models against a scenario of delayed or cancelled public contracts. Diversify revenue streams towards privately funded projects and international markets. Engage with the government to co-finance critical infrastructure through public-private partnerships. CFOs should revise UK revenue forecasts downwards and implement rigorous cost-control measures.

Outlook: The OBR's forecast confirms the UK is in a fiscally constrained, low-growth environment for the medium term. There are no easy solutions. The political cycle will create pressure for short-term remedies, but the underlying challenge is structural: a decade of near-stagnant productivity. (Scenario-based assumption: Without a sustained focus on politically difficult supply-side reforms, the UK will struggle to break out of the 1.5% growth trajectory). The outlook is one of challenging trade-offs, where every pound of new spending or tax cuts will require a corresponding, and likely painful, saving elsewhere. Stability and predictability will be valued above all else by markets and businesses.