Less than three months after she tabled her first Budget, Rachel Reeves finds herself in treacherous fiscal waters as rising UK borrowing costs erode her room for maneuver.
There is a real risk that the Chancellor will be forced to impose tougher fiscal policy as early as March, when the Office for Budget Responsibility releases its forecasts, as he seeks to meet self-imposed budget constraints.
The situation is detrimental to the Labor government, given that Mr Reeves has claimed that October’s fiscal report was a landmark effort to “rebuild” Britain’s fiscal woes. .
How did Britain go off course?
The central issue is the steady rise in borrowing costs for governments in the UK and around the world. The United States has been a central factor in the global bond sell-off in recent months, driven in part by expectations that President-elect Donald Trump’s tariffs will accelerate inflation.
However, the UK in particular has been hit by fund manager fears that the economy is entering a period of ‘stagflation’, with persistent price pressures prompting the Bank of England to cut interest rates to boost the economy. I can’t.
Concerns about stagflation, coupled with an expected increase in bond sales after the Budget, have pushed the UK’s 10-year borrowing costs to their highest level since the 2008 global financial crisis, and 30-year borrowing costs to the highest level this century. Ta. It also triggered a decline in the pound.
Jim McCormick, macro strategist at investment bank Citi, said: “The mix of pressures on both the British bank and the currency suggests that markets are increasingly worried about a UK recession or fiscal event.” ” he said.
Why is this so harmful?
Rising borrowing costs are already having a direct impact on Mr Reeves’ budget plans, increasing interest payments by more than £100bn a year.
She set a goal to balance the current budget, excluding investment spending, by 2029-30. Forecasts from fiscal watchdog the Office for Budget Responsibility in October suggested Mr Reeves would hit the rules with a margin of £9.9bn in the same year.
But rising interest rates are putting her goals in jeopardy. Long-term Treasury yields have been rising steadily in recent weeks, with the 10-year Treasury yield rising to 4.82% on Wednesday, its highest level since 2008.
Some content could not be loaded. Please check your internet connection or browser settings.
Ruth Gregory, an economist at consultancy Capital Economics, said the moves seen so far were enough to eliminate the slack on the current budget rules, which the Treasury now exceeds by almost £1 billion. He said it was a powerful move.
This estimate is based on the BOE’s benchmark interest rate and the market’s implicit expectations for the 20-year Treasury yield.
“Compliance with fiscal rules is non-negotiable and no one should doubt the government’s iron grip on public finances,” the Treasury said on Wednesday. “Only the OBR’s forecasts can accurately predict how much leeway the government has. Anything else is just guesswork.”
Are other factors taking a toll on your finances?
The OBR forecast released on March 26 also shows a revision to the growth outlook, which will also have a significant impact on public finances. Gross domestic product data at the end of last year was weaker than expected, with the BoE estimating that the economy did not grow in the final three months of 2024.
Analysts said the weak data appeared to jeopardize the OBR’s forecast for economic growth of 2% in 2025, published in October.
However, the impact of GDP developments on borrowing will depend on whether the OBR judges that the economy has recovered enough to make up the shortfall later in Parliament, or that a permanent loss of production has occurred. .
If the OBR downgrades its view on the UK’s productivity and growth potential, it would be a further blow to the Treasury and public finances.
What can Reeves do?
The deterioration in Britain’s fiscal outlook comes as the government prepares for the next stage of its multi-year spending review, the outcome of which is expected in June.
The Treasury set spending limits for all Whitehall departments in its October budget, with day-to-day spending set to increase by 3.1% in 2025-26, before sharply declining to a real growth rate of 1.3% in 2026-27. is.
Detailed plans for the first year have been set. The review of expenditures is currently focused on the next fiscal year. Officials have suggested that if Reeves needs to make fiscal policy adjustments this spring, it will likely be by tightening spending plans rather than raising taxes sooner.
That’s because she has pledged to hold only one “fiscal event” each year, and that’s when taxes change, which won’t happen until the fall.
Some content could not be loaded. Please check your internet connection or browser settings.
Associate Ben Zaranko said tightening spending plans to restore spare capacity to October’s level of just under £10bn would limit real growth in day-to-day departmental spending from 1.3% to just under 1% a year. Said to mean that. Director of the think tank Institute for Fiscal Studies.
But analysts worry that if the bond market decline drags on, Reeves could be forced to do more to support fiscal credibility. Such measures could involve tax hikes and front-loaded spending cuts, as well as pledges for more discipline later in Congress.
“In an already depressed economy, Mr. Reeves could soon face a thorny choice between breaking fiscal rules and announcing more tax increases and spending cuts,” said Capital Economics’ Gregory. ” he said.
What other options do I have?
The chancellor aims to focus on “pro-growth” rhetoric in the coming weeks, with faster economic expansion likely to deliver fiscal benefits.
Reeves is preparing for a trip to China this week as he looks for ways to stimulate the economy.
But hopes for a strong turnaround in GDP growth could easily be disappointed. Investors are warning that the current Congress’ attempts to build a solid fiscal foundation are in jeopardy as the decline in bond prices intensifies.
“Given the relentless sell-off since October, there is no room left for Reeves,” said Pooja Kumra, UK rates strategist at TD Securities.
Data visualization by Keith Fray