I'm asked to discuss the IFS Green budget (this means their budget analysis, nothing to do with the environment specifically). Here is their analysis and my comments, labelled "comment".
1. Backdrop: growth decelerating, unemployment and inflation rising. But near-term outlook: inflation falls to target and growth comes back a bit, from previous monetary loosening.
2. Near term outlook depends on: what happens to current high savings, population./migration and productivity.
3. What matters? In the near-term, Bank of England easing, the budget. in the medium term, TFP is expected to pick up.
Activity
4. the key is the public sector and migration. "with private domestic demand just 2% above its pre-COVID level compared with an increase of 16% in the rest of the economy over the same time frame. The public sector and net trade have instead played an outsized role in driving recent growth, alongside an expanding population, itself driven by net migration. Real GDP per capita grew just 0.1% year on year in 2024, followed by 0.7% in the first half of 2025."
hence the key questions:
a. can the private sector fill the gap?
b. if migration falls, will productivity rise to drive growth?
They say yes:
5. on disposable income, a target for the government, some progress is expected.
6. on investment, the position is extraordinary.
a. revisions have raised investment. "Business investment is now estimated to have been 6.8% higher than its pre-COVID peak in Q2 2024, compared with just 0.4% above in the data that underpinned the OBR’s March forecast".
b. but the biz invest/GDP ratio is 11 in 2025Q2. It's 16% in the US and 17% in Germany.
c. margins have been squeezed, depressing investment.
d. even stronger investment will not be enough to close the Allas and Zenghelis (2025 capital gap. My comment: their estimates run from 50-12% less capital per hour than peers, with a central one of 33%. I am closer to 12% then 33%.
7. Trade.
a. "the effective tariff rate on UK goods exports to the US, which make up 16% of total
UK goods exports, has increased 8 percentage points to 9%. Application of macroeconomic
multipliers would suggest that this reduces UK GDP via a direct trade channel by 0.1–0.2
percentage points by the end of 2026"
b. "Yet, for a small, open economy such as the UK, and especially one whose activity is more
heavily focused in the service sector as opposed to goods production and manufacturing, it is the
increased uncertainty and the global trade slowdown, rather than the direct impact of tariffs
applied to the UK, that has the larger consequence"
8. the labour market.
a. "we judge the labour market to be loose. Vacancies in the economy continue to fall and the ratio of vacancies to unemployment is now comfortably below estimates of the equilibrium rate"
b. "With inflation easing and a loose labour market, we expect nominal wage growth to slow to 3–3.5% in the coming 12 months and to settle around 2.5–3% from mid 2026 onward. We expect improving productivity to allow for 0.5% annual real wage growth with unit labour costs growing at a rate consistent with 2% inflation.
One risk to this outlook is that workers look to catch-up perceived past real income losses (Haskel, Martin and Brandt, 2023; Bernanke and Blanchard, 2025). We judge this to be a limited risk. Extrapolating a trend for real earnings growth up to the start of the pandemic and then playing it forward would suggest that this process is already complete and historical losses have been regained (Figure 1.9)."
Comment. this is interesting, but it depends on stable inflation expectations. There is some evidence this is rising. So I think there may be more wage pressure. My reading of the Bank work is that there is is still unexplained upward wage pressure.
9. inflation
A graph of CPI
a. this is mostly driven by energy prices, administered prices (e.g. VAT on schools, Vehicle excise duty).
b. stripping them out give inflation looking much closer to 2.5% and likely to fall.
c. inflation expectations have risen, but to the extent this is due to food etc. they willl when the base effects fall away.
Policy
1. Monetary policy.
"the neutral rate, the appropriate path to follow has become even more unclear.
Despite the recent cuts to interest rates, monetary policy remains restrictive in an absolute sense and is weighing on economic output (Bank of England, 2025, box A). We view the nominal neutral interest rate as between 3% and 3.5% and so, without further easing, monetary policy is likely to continue to act as a headwind to growth and will weigh on inflation. What is more, the economy continues to be haunted by the ghost of tightening past. The lags between monetary policy decisions being taken and them affecting the economy mean that, even though the extent of restriction has been reduced, we are still feeling the effects of more restrictive rates from two years ago. This point can be illustrated by using granular mortgage data from UK Finance which show we are in the midst of a wave of remortgaging (Figure 1.18). People dropping off five-year deals will be moving to a rate that could be more than 2 percentage points higher than previously. This suggests that the cash-flow channel of monetary policy will bite for the foreseeable future."
"We continue to think that quarterly cuts to Bank Rate are the appropriate path for the MPC to take until the rate is closer to the neutral rate. If not, the risk is that the Bank ultimately has to cut faster and further, with a then-unavoidable undershoot of inflation in the interim. Current market pricing implies that Bank Rate will hit 3.6% in Q3 2026, roughly 0.2 percentage points below the level the OBR had assumed in March."
Comment. Much depends on what you think the neutral rate is. If U* has risen then policy needs to be tighter.
Fiscal.
1. "forecast assumes that this fiscal consolidation is achieved predominantly through a combination of extending the freeze on income tax thresholds beyond 2027–28 and a more frontloaded increase in the basic and higher income tax rates (1 percentage point on each). While this would contravene a government manifesto pledge, we judge this to be one of the few ways to raise sufficient funds credibly and reliably"
2. A major risk for this Budget (discussed in more detail in Chapter 2) is that the consolidation is insufficient to satisfy markets that we will not be back in the same position next spring, or autumn. ...another fiscal consolidation in the future ...would act as a further drag on growth. This can become self-fulfilling.....The government needs to break out of this cycle.
Comment. This is absolutely right.
The supply side.
The potential growth data are nicely set out
The population data are amazing.
"We calculate potential output growth has been under 1% in 2023 and 2024. This has been driven by growth in the population of the UK, which expanded 1.3% in 2023 and 1.1% in 2024. These were the highest annual growth rates since the series began in the 1940s. This population growth was almost exclusively a result of net migration flows, particularly from outside the EU. Net migration from the previous year to mid 2024 was 738,718,"
But the population growth figures are likely to fall "Lower net migration leads the working-age population to grow by an average of 0.7% per year"
"These downward trends are offset over the medium term by rising trend (and realised) total factor productivity growth, which we assume moves from –0.3% currently to 0.4% year on year by 2030. The latter effect dominates and the UK’s potential growth rate increases from around 1% in 2026 to around 1.5% by 2030 (Figure 1.23)."
Some issues with this
1. how does this compare with OBR?
"In March, the OBR forecast that output per hour worked, which had fallen
by 1.0% in 2024, would increase by 0.2% in 2025 and 1.1% in 2026, and by 1.3% in 2029–30. Outside
of the pandemic, the UK has not seen such rates of productivity growth on a sustained period in the
past 20 years. Our own forecast embodies an increase in output per hour worked of 0.8% in the
medium term. We condition it on the same population projections used by the OBR in March, and
broadly similar expectations for declining average hours and participation. Our forecast is actually a
little more optimistic than the OBR’s on capital deepening. The biggest difference derives from our
differing views of total factor productivity (TFP). The OBR assumes this will average 0.8% annually
over the forecast and reach 1% by 2029–30. This is roughly 0.6 percentage points higher than the path
in our forecast by 2029–30."
2. what might affect productivity?
"Faster adoption of AI. We have seen significant global investment in the infrastructure required for
AI, and plans for this to accelerate in the UK (Department for Science, Innovation and Technology,
2025; Pabst and Marioni, 2025). There are signs that UK firms are increasingly adopting AI, with
55% of firms answering the Bank of England’s Decision Maker Panel already using it in some form
and an expectation this could increase 10–20 percentage points in the next three years.
▪ Realigning trade with the EU and greater openness. Evidence suggests that more open economies
are more productive, with better generation and diffusion of innovation (D’Aguanno et al., 2021). The
UK has seen the negative consequences of this since Brexit, with estimates suggesting it has reduced
productivity by 4% (Office for Budget Responsibility, 2020; Dhingra et al., 2016). Current government discussions with the EU could reverse some of this trend if they can lead to a more flexible labour market (e.g. the Youth Mobility Scheme), sharing of R&D resources and reductions in the costs of doing trade. That said, as discussed above, the trend globally is for less openness to trade, not more.
▪ Fiscal and political stability crowding in productivity. There is an established link between political, fiscal and economic uncertainty and productivity and growth (Hong, Ke and Nguyen, 2024; Bloom, 2007). The UK government currently has a large parliamentary majority and no requirement to call an election for four more years, and if it can maintain stability of both policy direction and tenure then there could be a dividend in the form of better productivity performance.
▪ Public sector productivity increases. Partly as a consequence of the above, public sector productivity increases may be able to leverage the developments above (AI, openness, stability) to improve. However, even the current plans may seem optimistic, as discussed in Chapter 6."
Some overall comments.
1. The fiscal problems must be solved. We cannot have another year of minimal headroom and higher taxes that might or might not raise money. The attendant uncertainty will be terrible for investment and confidence.
2. I am less hopeful about interest rate cuts. Current rates are 4%. "Current market pricing implies that Bank Rate will hit 3.6% in Q3 2026," says the report. "Our relatively benign economic outlook is predicated on the Bank of England continuing the trajectory it has been on since August 2024 and removing further policy restraint over the coming months, taking Bank Rate to 3.5% – which we judge is within the plausible range of estimates of the UK’s neutral rate, the short-term interest rate that neither adds to nor subtracts from inflationary pressure – by the end of Q1 2026." Thus they are more hopeful than the market about rate cuts. I am pessimistic. I think the labour market has deterioriated and the natural unemployment rate has risen: I note that the Bank still has unexplained wage pressure in its wage equations. Thus I would not expect so many cuts.
Why has U* risen? The extension of NI contributions to the lower paid would have been bourne by workers but it cannot be with the surprise rise in the NLW. An additional rise to U* will come from the so-called Employment Rights Bill.
3. Regarding TFP, estimated at around -0.2 for 2025 but forecast to rise to 0.2%ps in 2030, with the OBR expecting 0.8% and 1% by 2029, we have the following.
a. market sector TFP was 0.8 and 1.9 1991-95 and 1995-00, falling to 0.2 2011-18 and -0.4 2019-23.
b. but that is misleading. The "resource" sector, ag, mining, gas, elect, water, construction is very volatile, especially mining. Without this sector, market sector TFPG is 0.5%pa 2011-18 and -0.1%pa 2019-23.
c. the sector that's powering TFPG is ICT service, (sector J, info and comms services), contributing +0.4%pa 2019-23 (in the US 0.5). What the US has seen is a rise in the use of those services, notably, software, with non-ICT services contributing 0.4%pa. In the UK, that sector is contributing -0.3%pa. So an optimistic take is that sector starts to contribute, or at least not be negative. If not negative, the non-resource TFPG would be 0.2. So one justification for an 0.2% rise, at least for the private sector is that.
d. Buts, First, TFPG and intangible investment in services depends on many things, but in part on labour market regulation. This will tighten with the Employment Rights Bill and so lower intangible investment.
e. But also we have negative TFPG in the public sector, particularly health. What do we know about this? The ONS publish "public service productivity", see here for the latest. This meaures "Public service productivity is measured differently to labour productivity and multi-factor productivity and is not directly comparable. It reflects the volume of services delivered to end users, relative to the volume of total inputs (which include labour, intermediate consumption, and capital). The measure is dominated by healthcare and education services because of their relative size. "
So it is a sort of TFP measure and shows a lower level than 2019
Source: ONS. Notice that quarterly estimates differ from annual with no quality adjustments and less full breakdown of inputs via COFOG.
More on how the ONS calculate outputs and inputs is here. Broadly speaking, capital, labour and intermediate inputs are collected for different types of inputs.
e.
