The March 2026 publication of the Office for Budget Responsibility’s forecast for the UK unfortunately coincided with the outbreak of the Middle East war. The resulting turmoil in fuel and financial markets has significantly increased existing doubts about the sustainability of current UK policy.
Continuing the regrettable practice of recent chancellors, the 2025 budget frontloaded the increases in public spending and backloaded the income tax rises. The government and its restive MPs may not be content to approach the next general election with an implausibly slow growth of public spending and supposedly ‘stealth’ income tax rises (which would be apparent to all) occurring simultaneously. This fragile fiscal balancing act was further at risk from half-acknowledged pressures to increase defence spending.
The Middle East war has fundamentally changed the short-term outlook. Increases in energy prices will, if sustained, lead both to inflationary pressures and calls for government to mitigate the negative effects on living standards. These would require responses from both the monetary and fiscal authorities, which could not easily be coordinated given the separation of responsibilities between the government and the Bank of England.
Mitigating negative effects on living standards
After the three major shocks of the early 21st century – the 2008 financial crisis, the Covid-19 pandemic in 2020 and the Russian invasion of Ukraine in 2022 – the policy response to the negative effects on living standards and employment was a combination of monetary and fiscal relaxation.
With inflation currently above target, monetary relaxation would not be appropriate. The legacy of fiscal largesse in the previous crises – high debt-to-gross domestic product ratios, a massive debt interest bill and the highest government bond yields in the G7 – means that bond markets would not allow significant fiscal easing.
Any government-funded relief for groups vulnerable to energy price increases would have to be financed by tax increases or spending cuts elsewhere. Whether any changes to fiscal policy can wait for the autumn budget will depend on the severity and duration of the shocks to energy and financial markets.
Pre-war fiscal pressures
There have been elements of denial and evasion in the UK government’s pre-conflict fiscal plans. The planned slow growth of spending on public services in the later years of this parliament will cause massive problems for service providers. There has been no real embrace of tax reform. Most importantly the remorseless and unsustainable growth in spending on pensions and benefits needs to curbed: there is no case for leaving this problem to the next parliament.
Finally, the government has left defence spending in a fiscal no man’s land: in line with Nato aspirations, it has committed to increases in defence spending as a share of GDP, but has not incorporated these increases in its fiscal projections, leaving defence planners uncertain when their budgets will increase and by how much in particular years.
This approach both increases the difficulties of managing defence spending efficiently (a real concern given the UK’s poor record in this area), but also progressively undermines the credibility of the government’s fiscal policies. It is in neither the Treasury’s nor the Ministry of Defence’s interests for uncertainty about the path of future defence spending to persist.
The fiscal consequences of war in the Middle East
The rise in world energy prices will, if sustained, lead to upward pressure on UK consumer price inflation and industrial costs plus downward pressure on real incomes. Precisely how consumers and companies are affected will depend on the policy responses. Past experience suggests that the principal concern of government will be to mitigate the adverse effects on consumers.
The policy responses could take four principal forms. First, to counter rising inflation, the Bank of England could raise interest rates rather than cut them as had been expected pre-crisis. The disadvantage of controlling inflation primarily through interest rate hikes is that the burden of adjustment falls disproportionately on those with mortgages and largely spares older householders, who in any case will be protected by the pensions triple lock (unless it is suspended).
Second, the government would therefore be tempted to reduce energy price inflation by subsidising fuel prices in the same way as after the Ukraine invasion. In effect the role of controlling inflation would be temporarily shared by the Bank of England and the government – a process for which there are no formal arrangements. An early fiscal intervention to control inflation would at least partially offset the second-round inflationary impulse from the UK’s price indexation arrangements (both formal and informal). The disadvantage of this approach is that it would be untargeted by benefitting even the wealthy and would be extremely expensive.
Third, a cheaper alternative for government would be to direct income subsidies to poorer groups. However, this option would leave recorded inflation unchanged and leave the second-round inflationary effects through indexation unchanged.
Finally, while the government is likely to be overwhelmingly preoccupied with protecting consumers, it may have to consider helping industrial sectors hardest hit by energy price rises, particularly if significant job losses seem likely. The fact that some sectors are already struggling with higher national insurance contributions and increases in the minimum wage could mean that they will be particularly vulnerable to higher fuel prices.
Changes in fiscal policy are likely
With debt-to-GDP ratios and gilt yields at current levels all these options, except a rise in short-term interest rates, would involve increases in public expenditure that could not be financed by higher borrowing and would require offsetting tax increases or public spending cuts that would not be easy to agree. This unenviable position is the result of failing to reduce government debt ratios after the three previous shocks in the 21st century.
When and whether any possible fiscal changes are announced will depend on the duration of the Middle East conflict and the extent that world energy prices rise. The longer the war and the greater the energy price spikes, the more likely that there will be fiscal policy changes announced before the autumn budget.
Peter Sedgwick was a senior Treasury official, a Vice President of the European Investment Bank 2000-06, Chair of 3i Infrastructure PLC 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19.
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