Rachel Reeves Faces Continued Fiscal Constraints in 2026 Despite Growth Hopes

The UK Chancellor Rachel Reeves confronts another year of challenging economic conditions in 2026, according to Morgan Stanley’s latest outlook. The bank’s analysis suggests that hopes for increased fiscal flexibility through improved economic growth remain unlikely to materialise, with constraints similar to those experienced in 2025 set to persist.

Morgan Stanley forecasts GDP growth of just 0.9% for 2026, a significant decline from the 1.4% expansion anticipated for 2025. Real disposable income growth is expected to moderate to 0.5% next year, down from 4.1% in 2024 and 1.5% in 2025. This subdued economic environment offers limited scope for the Treasury to benefit from buoyant tax receipts.

The household sector appears set to maintain a cautious stance, with the savings rate projected to remain near 10%, well above pre-pandemic norms. Consumer spending is forecast to increase by a mere 0.3%, insufficient to generate the VAT and income tax revenues the government requires. This defensive positioning reflects continued uncertainty among households about their economic prospects.

Business investment momentum is also expected to weaken. Whilst companies in utilities, transport, real estate and technology sectors have maintained surprisingly robust investment despite elevated borrowing costs, Morgan Stanley anticipates a slowdown as confidence softens and credit growth moderates. Business investment growth is projected to decline from 3% in 2025 to 2.1% in 2026, whilst residential investment follows a similar trajectory as the effects of earlier rate cuts fade.

The labour market presents additional concerns. Unemployment is forecast to rise to 5.3% in the first half of 2026, up from 4.8% in 2025. Vacancies have contracted, payrolls have declined and candidate availability has increased. Reduced migration flows are now constraining labour supply growth, which prevents unemployment from rising more sharply but also removes a key source of economic flexibility that has operated in recent years.

Wage growth is expected to cool to approximately 3% by the end of 2026, consistent with the inflation target but insufficient to generate meaningful increases in tax receipts. Morgan Stanley characterises the period as one of “elevated slack”, describing an economy that is neither in crisis nor generating the dynamism the Chancellor requires.

Inflation is anticipated to reach the 2% target in April and remain close to that level throughout 2026. Softer wage pressures, easing administrative price increases, lower utility bills and more benign goods inflation all contribute to this outlook. Services inflation, historically the more persistent component, should moderate as labour costs normalise and last year’s national insurance rise drops out of annual comparisons.

Whilst lower inflation provides some relief by reducing the government’s interest bill and uprating costs, the fiscal dividend remains modest. Real-terms spending plans remain tight, with the deficit projected to stay just below 4% of GDP. Morgan Stanley identifies the 2027 Spending Review as the most difficult fiscal moment of the current Parliament, when the Chancellor must choose between increasing funding for squeezed departments, loosening her fiscal rules or testing market patience.

Reeves entered 2025 in a constrained position following tax increases of approximately £40 billion in her first fiscal package. Described as a one-off reset, these measures have left limited political capacity for further taxation of working-age taxpayers. Simultaneously, the Chancellor has committed to avoiding a return to austerity whilst binding herself to rules requiring debt to fall. This creates what economists term an “impossible trilemma”, whereby debt rules, tax restraint and public service demands pull in conflicting directions.

The Office for Budget Responsibility has repeatedly downgraded productivity and growth forecasts, mechanically reducing Reeves’s fiscal headroom. Each downward revision pushes the government towards unpalatable choices: additional taxation, increased borrowing or tighter spending precisely when voters expect visible improvements across public services from the NHS to local authorities.

To achieve a more successful 2026, the Chancellor requires a clearer communication of trade-offs, tighter focus on growth-enhancing reforms and sufficient political capital to adjust fiscal rules if necessary. This entails transforming the trilemma into a more credible, prioritised strategy that maintains confidence among markets, voters and the OBR alike.

Re-anchoring expectations represents the first priority. A multi-year framework for taxation, investment and public services that acknowledges constraints whilst pointing towards stronger medium-term growth appears essential. This likely requires explicitly prioritising capital spending that enhances productivity in infrastructure, housing, energy and skills, even if this necessitates re-profiling or loosening elements of current fiscal rules. Continued reliance on ever-tighter departmental budgets lacks credibility and will prompt further OBR downgrades that erode available headroom.

Visible improvements that households can experience represent another critical requirement. Whilst inflation returning to target provides relief, and the Bank of England’s expected path towards a 3% policy rate eases cost-of-living pressures, measurable progress in NHS performance constitutes the flagship test of the government’s programme. This demands not only funding but operational reform to ensure additional resources deliver shorter waiting lists rather than being absorbed by demographic and pay pressures.

The Chancellor maintains that stability and firm fiscal rules provide the foundation for growth. Success in 2026 depends on whether this stability can be matched with a more ambitious supply-side agenda. Planning reform to accelerate delivery of roads, homes and energy projects, a more investment-friendly tax environment and predictable regulation for sectors including clean energy and advanced manufacturing all play central roles in raising potential growth.

Morgan Stanley notes that potential growth could reach 1.4% in 2026 and 1.5% in 2027 as productivity improves and early artificial intelligence diffusion takes effect. This represents one of few genuine bright spots in the outlook. However, if the OBR continues to downgrade medium-term growth and the Chancellor refuses to adjust either her rules or the policy mix, 2025’s pattern risks repeating itself.

Politically, rebuilding the narrative appears essential. Early tax increases and difficult decisions were presented as a transitional down payment to stabilise public finances. By 2026, evidence must demonstrate that growth, wages and employment are outperforming peer economies rather than lagging them. Without such proof, the government may find itself judged against its own early rhetoric, including the commitment to become the “fastest growing economy in the G7”.

Some positive elements exist within the forecast. Productivity shows improvement, the labour market, whilst softening, avoids collapse, inflation returns to target and potential growth appears slightly better than previously feared. Critically, fiscal constraints remain tight but are not intensifying. The deficit edges lower, debt rises only gradually and markets remain calm.

Stability may not constitute the prize the Chancellor anticipated. Given the difficulties of 2025, however, it represents a foundation upon which to build. For 2026 to appear markedly better than a challenging 2025, a clearer strategy, consistent communication and decisions about which elements of the trilemma to relax all appear necessary. Without such adjustments, next year risks becoming another iteration of the constrained, attritional politics that characterised the first full year of this administration.