Chancellor Faces Tough Choices Ahead of First Budget Amid Iran War Uncertainty

It is tough," John Healey admitted to me earlier this month when I asked him if there had been too much doom-mongering?

"Conflicts, uncertainty, driving up inflation, driving up interest rates. But we've got great strengths. We've got good reasons to be confident about the future of Britain," he insisted.

The new scheme to try and help young people get on the property ladder, announced on Saturday, was aimed at boosting confidence in the economy.

But the chancellor is now facing two big decisions before his inaugural Budget on 28 October.

Firstly, about the longevity of the economic pressures caused by the Iran War, and then about how to sustain a modest but notable uptick in economic spirits, through yet more global turbulence.

In his first weeks as chancellor the oil price fell as low as $75 a barrel while the yield - the effective interest rate - on 10-year government bonds was 4.9%.

Just over two months later oil has largely traded above $100 and the 10-year yield is at around 5.4%. It is the ultimate double whammy for a chancellor facing his first Budget.

Yet there is something unusual about this energy shock. It could quickly reverse, as illustrated earlier in the summer when assumptions about a deescalation in the US Iran conflict led to sharp falls in energy prices and yields.

In New York this week both President Trump and his Iranian counterpart President Pezeshkian suggested November's US midterm elections were connected to when the war might end.

The Iranians would wait until after the elections to seek peace because the war's impact on the cost of living - particularly soaring diesel costs - could damage him electorally, the US president told the UN General Assembly.

The Iranian president said his nation "didn't want it to get to the midterms".

Both sides in this war are feeling the economic squeeze of conflict.

The 3 November vote is six days after the Budget. No one could rely on there being a settlement by then, but it is plausible.

So the Budget tax, spend and borrowing forecasts could be based on a prolonged conflict, which is actually on the cusp of ending, or even already ended.

The chancellor has to therefore decide whether to plan for the worst, and make some painful permanent tax and spend decisions, or buy some time.

One option is to let borrowing take some of the strain, by tolerating a reduction in the £24bn of headroom - room for manoeuvre against its self-imposed borrowing rules - left by his predecessor, Rachel Reeves.

This year's headroom will be judged in three years rather than four, so there is some rationale as to why a smaller number over a closer target might be appropriate.

And while higher inflation means higher interest costs, it also means higher cash tax receipts, at a time when thresholds continue to be frozen.

There is a second consideration. The hopeful optimism "vibes" strategy of the Burnham administration appears to have had some impact.

The longest running UK consumer confidence survey has hit a two-year high. Among younger people it has not been this high since before Brexit.

Some data companies call it a "Burnham bounce", although the weather and World Cup were also factors.

There is evidence, more mixed, that business optimism has also perked up in recent months, possibly because of earlier falls in energy prices, though this has been clouded by anticipation of possible tax rises. Business group, the Institute of Directors said this was despite, rather than because of, the new government.

While no one should get too carried away with these turnarounds, they do stand in contrast to the admitted mistake of the Starmer government in talking up consumer pain, two years ago.

The question for the chancellor is whether better consumer and business spirits can be reconciled with the need for a "challenging" Budget?

Indeed, it's important to determine how much of the summer global bond market shock is solely down to the impact of the Iran war and how much is more structural.

Governments are facing new and intense competition in bond markets from the world's biggest AI businesses. In addition, the UK has had recent, prominent political and economic uncertainty.

Right now the bond markets are like a pack of wolves stalking red deer, probing for weaknesses.

"At times like this you don't want to be at the back of the herd," said one very senior former Treasury adviser.

In response, the Treasury has pointed to the UK having the highest growth and the fastest falling borrowing of the major G7 countries so far this year and our overall energy prices starting to decouple from high and volatile gas prices.

However, the IMF chief Kristalina Georgieva this week dismissed the idea that advanced nations could pause their fiscal homework, while the Gulf situation calmed.

"Bring debt levels down, make fiscal consolidation as a priority… it is impossible to stress strongly enough how critical it is to get the courage to take the steps that are necessary," Georgieva told me, acknowledging the UK's "fairly consistent, credible" plans.

Then there is the curious conundrum of British productivity. Last year, the government's official forecaster the Office for Budget Responsibility (OBR) downgraded the UK's productivity peformance, leading to a notable hit to the public finances.

Now the UK's productivity record has been upgraded materially by the Office for National Statistics, although this is because of fewer hours worked. There could therefore be an argument to reverse some of that downgrade.

Separately, the new chair of the OBR Jonathan Haskel is known for his argument that official statistics understate investment in intangibles like software and data. His latest research suggests AI-related investment is already visible in US productivity figures, and he has long been optimistic about tech's impact on the future.

While it seems unlikely that such factors will make it into the OBR's calculations next month, there is a real debate here.

Officially, however, part of the job at the Budget is to identify cuts to fund the Defence Investment Plan, inherited from Sir Keir. That's before funding the additional move to 3% of GDP and a new social care system.

Even a promise of less welfare spending looks like being built on an upfront investment in jobs for young people.

One change from last year is that so far, the government has parked the "pitch-rolling" with a silence that would rival the Trappist monks.

Instead, policy announcements are strategically timed such as the "Your First Home" scheme just as the Labour party conference got underway. We can expect to hear plenty more as the Budget nears.