UK Budget buys the government time, but fiscal questions remain
29 OCT, 2026
By Peder Beck-Friis from PIMCO
The Chancellor said the aim of the Budget was to offer some “breathing room” in the face of rising prices, but its main effect may be to give the government itself some breathing room. While markets reacted calmly to a package that was modest by recent standards and almost exactly as announced, attention will now turn to a long list of pressures and decisions deferred to next year’s Spending Review.
Fiscal headroom matters less than markets think
Much of the public debate ahead of the Budget focused on the government’s “fiscal headroom”. In the end, that headroom came in at £15 billion, lower than before. Although this was expected, in our view the importance markets attach to fiscal headroom tends to be overstated. It makes far more sense to focus on the near-term path of the deficit and on gilt issuance.
The government’s plans for measures it intends to implement by 2029-30 (the year in which compliance with the fiscal rules is assessed) are unlikely to carry much weight with markets, not least because it may be an election year. Moreover, whether headroom is a few billion pounds higher or lower matters far less than the much greater uncertainty about the state of the economy and public finances several years from now.
The Office for Budget Responsibility (OBR) now forecasts the deficit to fall from 4.2% of GDP this year to 3.4% next year, before settling at around 2% in three years’ time.
A deficit-reduction plan that keeps slipping
On paper, the UK’s deficit-reduction plan remains one of the most ambitious among developed economies. However, this Budget once again saw the plan pushed back, with forecast borrowing revised up across the entire forecast horizon and year-on-year progress on deficit reduction having all but stalled in the current fiscal year.
As with last year’s Budget, the Chancellor chose to loosen fiscal policy in the early years, increasing public spending and offsetting this with the prospect of higher taxes later on, albeit on a smaller scale than in previous Budgets.
We attach little credibility to detailed long-term deficit-reduction plans beyond next year. However, if the government manages to bring the deficit down to around 3.5% next year, as forecast, that would be a significant achievement and would help restore fiscal credibility. There are, nonetheless, some reasons for caution.
Uncertainty over the public finances will persist into next year and, if recent years are any guide, further slippage against fiscal targets is likely. Spending pressures are building ahead of next year’s Spending Review, including on defence. We also note that the fuel duty freeze and the extension of the VAT cut on domestic energy are both currently set to expire in July. Given that few observers expect these measures actually to be allowed to lapse, it is clear that yesterday’s Budget is not the final word.
Although the details of next year’s financing requirement remain uncertain, the direction still matters. If the deficit were to fall to “three-point-something”, we expect bond markets to become less sensitive to fiscal and political news over time. That level is not far from what is needed to stabilise the debt-to-GDP ratio. The rest of Europe offers a useful comparison. Markets remain on high alert over fiscal and political developments in France, where the deficit exceeds 5%, but are far less concerned about next month’s elections in Spain, where the deficit is between 2% and 3%.
Gilts: a monetary story more than a fiscal one
UK government bonds (gilts) continue to price in a modest fiscal risk premium, with a yield curve slightly steeper than in most other developed countries. Eliminating the remaining premium will require continued evidence of deficit reduction.
However, the main reason gilt yields are high is monetary rather than fiscal. The Bank of England’s policy rate is high at 3.75%, and markets have already priced in a further four or five rate hikes. The Budget did little to shift these expectations.
The government announced some moderately disinflationary measures, but they are limited in scope against the broader uncertainty surrounding inflation and energy prices.
With the Budget now behind us, attention will return to inflation, growth and the outlook for the Bank of England (BoE). Growth has surprised to the upside, the labour market appears to be stabilising and there are still-tentative signs of firmer core inflation. However, we see few signs of the economy overheating and consider it unlikely that the degree of monetary tightening currently priced by markets will materialise. Against this backdrop, we continue to see UK gilts as attractive within a diversified global fixed income portfolio.
