A view from London

Third, like his predecessor, the chancellor announced an easing of policy in the short term to be offset by tightening later. This adds to the significant fiscal squeeze already pencilled in for the end of this parliament following previous budgets. Two-thirds of the deficit reduction promised over this parliament is to come in its last two years - between 2027 and 2029 - and is contingent on deep cuts to departmental spending. Delivering that over the potential run up to an election is likely to be politically challenging.

Fourth, the fiscal headroom - the margin by which the government meets its fiscal rules - has reduced to £15bn. The Office for Budget Responsibility (OBR)'s calculations for it assume a rise in fuel duty next year, which successive governments have struggled to implement since 2011. Given the current Labour government's focus on the rising cost of living and the risk of elevated inflation, the duty seems likely to remain frozen throughout this parliament, which would amount to a further reduction in the headroom of £4bn, leaving a narrow buffer. This makes fiscal policy more vulnerable to external shocks and subject to uncertainty.

Fifth, this Labour-led parliament is presiding over a fiscal consolidation programme relying almost entirely on tax rises. As the chart of the week below shows, this is the sharpest tax-led retrenchment the government has undertaken since the second world war. Bigger consolidations have relied predominantly on spending cuts.

In fact, several studies show that successful fiscal consolidations tend to place more weight on reductions in public expenditure than on raising taxes. There are risks to relying solely on taxes to fix public finances. A study of fiscal retrenchments by Harvard economist Alberto Alesina and co-authors in 2018 found that tax rises tend to have a greater dampening effect on growth than spending cuts.

As the briefing above explains, the current Labour-led parliament is presiding over a period of significant fiscal retrenchment. According to estimates from the Office for Budget Responsibility (OBR), between the beginning and end of this parliament, national taxes as a share of GDP will have risen by 3.8 percentage points while spending will have increased by 0.8 percentage points.

Together, that will amount to a consolidation worth 3% of GDP, the biggest tax-led fiscal retrenchment since the second world war. Consolidations such as this are rarer than those driven by cuts in public expenditure because tax rises tend to be a bigger dampener of activity than austerity.

First, global adaptations to the energy shock - from strategic inventory drawdowns and Gulf producers rerouting supplies, to increased production by other exporters and substitution to alternative sources of energy - have cushioned the impact on global growth. The IMF estimates that this flexibility of supply and the reduced oil intensity of global activity since 2010 have together counteracted almost two-thirds of the impact of the closure of the Strait of Hormuz on global growth this year.

With energy prices and inflation set to stay higher for longer, the energy shock remains a drag on global growth but not as severe as expected earlier. 

The second, and perhaps deciding, factor behind improved growth prospects is AI. For now, the boost comes not from realised productivity gains but from booming investment in data centres. This is driving demand for semiconductors, computing and power generation equipment, and boosting international trade.

Higher technology share prices are also supporting consumption through wealth effects. The Dutch banking group ING estimates that AI-related activity has accounted for about one-third of US growth this year, with significant spillovers to other economies integrated into global technology supply chains. Asian nations central to the AI supply chain, such as Taiwan and Korea, have seen hefty upgrades to their IMF growth forecasts.  

In fact, the improvement in global prospects masks significant divergence in outcomes across economies, depending on their exposure to the conflict and their ability to benefit from the AI boom.

Gulf economies directly affected by the conflict have borne the brunt of it. Disruption to oil and gas production and exports has depressed headline GDP, while restrictions on air travel and weaker tourism and trade have damaged non-oil activity. Rerouted exports and higher energy prices have softened the impact, but significant contractions are still expected in major regional economies, including Saudi Arabia. 

Among major energy importers, China and India have absorbed higher import costs without a material deterioration in their growth outlook, supported by energy inventories and government intervention. Their size and policy capacity meant they were better placed to weather this shock than smaller importers with limited foreign currency reserves or room for fiscal support. Their strong connections to the technology value chain have also helped them benefit from the AI-driven boost in global trade.

The UK saw a significant improvement in its economic assessment, with the IMF raising its 2026 growth forecast from 0.8% in April to 1.3%. The upgrade largely reflects a better-than-expected performance in the first half of 2026, driven by strong growth in the information and communication and professional services sectors. That, alongside stronger business investment, suggests that AI-related activity may be beginning to support the UK economy.

Even so, higher inflation is set to overtake wage growth in the UK, squeezing real incomes and consumption over the winter months, while likely interest rate rises by the Bank of England place further pressure on activity. The IMF upgrade therefore reflects past strength more than an improvement in the outlook ahead.

For the global economy, the risks remain skewed to the downside. Developments in geopolitics or financial markets could still test its resilience. Meanwhile, AI has clearly delineated its short-term economic impact - it is a positive demand shock, driving investment and global growth.

An ageing population has pushed up welfare and healthcare spending in the US, with tax revenues yet to catch up. This, alongside a significant rise in debt interest payments, means the US government has been running persistent deficits, rising to around 6% of GDP recently - more than double the long-term average.

Without policy action to address this, US deficits are projected to continue rising and the Congressional Budget Office (CBO), an independent federal agency, expects public debt to grow over the next ten years at a faster pace than the US economy. Its latest forecast sees US government debt as a share of GDP reaching a new record high of 108% by 2030 and continuing to rise to 175% by 2056.

Such high levels of indebtedness wouldn't be unique to the US - Japan’s government debt is roughly twice the size of its economy. The US is also capable of sustaining higher debt levels due to the dollar’s dominant role in global trade and finance, which generates uniquely high demand for US treasuries.

But debt levels do impact its cost of borrowing. Yields on long-dated US treasuries have risen to a 24-year high recently, given concerns over its rising public debt alongside growing inflationary pressures.