As the Spring Statement nears, Rishi Sunak is left in a predicament amid mounting pressure to alleviate the cost of living crisis spurred by rising inflation and the economic fallout of the Ukraine conflict, a study says.
An analysis by the Institute for Fiscal Studies (IFS), published on Thursday ahead of the Spring Statement, lays bare the far-reaching economic challenges associated with the hurdles that lie ahead.
Britain's chancellor of the exchequer is due to unveil his budget on 23 March and faces calls to boost defence spending amid an economic war with tighter purse strings than in 2020 at the onset of COVID.
Traditionally, chancellors’ "mini-budget" statements contain fewer new tax or spending measures compared to a full budget in October.
According to the institute the shifting outlook might force the chancellor to produce more than just a new set of economic and fiscal forecasts.
"Households and public services will be squeezed by higher inflation, the economy rocked by heightened uncertainty, and the public finances buffeted by the fallout from Ukraine," the IFS said.
IFS's study says higher inflation "will wipe out at least a quarter of the real terms increases" to public service spending announced back in October.
It warned that if the government were to reflect the changing outlook in higher public sector pay awards, it would come at an additional cost of around £10bn ($13bn), or around £1,750 per worker.
Likewise, if the shifting forecast for inflation were not reflected in pay awards, the gross salary of the average public sector worker could reduced by around £1,750 in real terms. This would be on top of real pay cuts of between 5% and 10% for many public sector workers, it said.
Watch: How does inflation affect interest rates?
When it comes to household budgets, the IFS said Sunak would need an additional £12bn on top of the £9bn he already committed to in February to provide protection against higher prices.
Commenting on the predicament facing the chancellor, Paul Johnson, director of the IFS, said Sunak "has to make a huge judgment call".
He added: "Will he do more to protect households from the effects of energy prices which have risen even further in the last two weeks?
"If he doesn’t then many on moderate incomes will face the biggest hit to their living standards since at least the financial crisis. If he does, then there will be another big hit to the public finances."
The IFS says Sunak has to make at least three big calls:
Spend and borrow billions more, or allow a hit to household incomes bigger than at any time since at least the financial crisis and quite possibly since the 1970s
Impose severe real pay cuts on teachers, nurses and other public sector workers, on top of big cuts over the last decade, or spend much less than intended on other aspects of public services, or add even more to public borrowing
Leave defence spending as the only main element of government spending falling over the next three years, and falling much more than intended given current inflation, or find more money from additional borrowing
Johnson said while Sunak had "little choice" over big state action through the pandemic, his response to this crisis will reveal how he "sees the limits" of government in protecting citizens from "buffeting by external forces".
The UK inflation rate rose by 5.5% in the 12 months to January, up from 5.4% in December 2021, reaching a near 30-year high.
This was ahead of the 5.4% figure that economists expected, adding to the current cost of living squeeze. The inflation rate is currently more than double the Bank of England’s 2% target.
The Bank of England (BoE) warned in February that consumer price inflation could peak at about 7.25% by April when a 54% surge in energy bills is due to take effect, and Sunak's tax rises come into place. But Threadneedle Street has so-far underestimated the extent of inflation in previous forecasts.
It comes after BoE policymaker Jonathan Haskel recently warned that the geopolitical crisis between Ukraine and Russia could drive UK inflation higher.
Meanwhile, the Bank’s governor Andrew Bailey said that the central bank will need to respond to second-round effects from higher inflation if they happen.
Watch: Why are gas prices rising?