Less than three months after delivering her first Budget, Rachel Reeves is running into treacherous fiscal waters as rising UK borrowing costs erode her room for manoeuvre.
There is now a real risk that the chancellor will be forced to impose tighter fiscal policy as soon as March, when the Office for Budget Responsibility presents its forecasts, as she seeks to meet her self-imposed budget constraints.
The situation is damaging for the Labour government in light of Reeves’ claims that her October fiscal statement marked a landmark effort to “wipe the slate clean” when it comes to the UK’s budgetary woes.
How did the UK get blown off course?
The central problem is a steady rise in government borrowing costs, in the UK and around the world. The US has been a central factor in the global bond sell-off in recent months, partly driven by anticipation that tariffs imposed by US president-elect Donald Trump will fuel inflation.
But the UK has been particularly hit by fund managers’ anxiety that the economy could be entering a period of “stagflation”, where persistent price pressures prevent the Bank of England from cutting interest rates to boost it.
Combined with a rise in expected debt sales following the Budget, fear of stagflation has helped send the UK’s 10-year borrowing costs to their highest level since the 2008 global financial crisis and its 30-year borrowing costs to their highest this century. It has also triggered bouts of weakness for sterling.
“The mix of pressure on both gilts and the currency suggest the market is getting worried about a UK recession or fiscal event,” said Jim McCormick, a macro strategist at investment bank Citi.
Why is this so damaging?
The higher cost of borrowing has direct consequences for Reeves’ budget plans, by driving up interest payments that already exceed £100bn a year.
She has set herself the goal of balancing the current budget, excluding investment spending, by 2029-30. Forecasts in October from the Office for Budget Responsibility, the fiscal watchdog, suggested Reeves would meet the rule with £9.9bn of margin to spare that year.
But higher interest costs are putting her goal in peril. Yields on longer-dated gilts have been rising steadily in recent weeks, with the 10-year gilt yield climbing as high as 4.82 per cent on Wednesday, the highest since 2008.
Ruth Gregory, economist at consultancy Capital Economics, said the movements seen so far would be sufficient to more than erase the headroom against the current budget rule, with the Treasury now on track to break the rule by almost £1bn.
This estimate is derived from market-implied expectations for the BoE’s benchmark interest rate and the 20-year gilt yield.
“No one should be under any doubt that meeting the fiscal rules is non-negotiable and the government will have an iron grip on the public finances,” the Treasury said on Wednesday. “Only the OBR’s forecast can accurately predict how much headroom the government has — anything else is pure speculation.”
Are other factors hitting the public finances?
OBR forecasts due on March 26 will also set out a revised view of growth, which also has a significant bearing on the public finances. GDP readings in the tail-end of last year were weaker than expected and the BoE estimates the economy failed to grow in the final three months of 2024.
The poor data made the OBR’s October forecast for economic growth of 2 per cent in 2025 look vulnerable, analysts said.
But the effect of GDP movements on borrowing depends on whether the OBR judges the economy can bounce back and make up the shortfall later in the parliament, or whether it decides there has been a permanent loss of output.
A downgrade by the OBR to its view of UK productivity and potential growth would represent a further blow to the Treasury and the public finances.
What can Reeves do?
The deterioration in the UK’s fiscal prospects comes as the government prepares for the next stage of its multiyear spending review, whose results are expected in June.
The Treasury set out its overall Whitehall departmental spending envelope in the October Budget, with day-to-day spending due to rise by 3.1 per cent in 2025-26 before declining sharply to 1.3 per cent real-terms growth from 2026-27.
Detailed plans for the initial year have been set; the spending review is now looking at subsequent years. Officials have signalled that if Reeves needed to make a correction to fiscal policy this spring, it would likely come via tighter spending plans rather than early tax rises.
This is because she has vowed to hold only one “fiscal event” every year, which would be the time to change taxes and will not be held until autumn.
Restoring the headroom back to its October levels of just under £10bn via tighter spending plans would mean curbing real-terms growth in day-to-day departmental spending from 1.3 per cent a year to just under 1 per cent, said Ben Zaranko, associate director of the Institute for Fiscal Studies think-tank.
But analysts fear that if the sell-off in the bond market persists, Reeves could be forced to go further in a bid to underpin fiscal credibility. Such action could entail tax rises and front-loaded spending restraint, and not just vows of greater discipline late in the parliament.
“Reeves could soon face a nasty choice of breaking her fiscal rules or announcing more tax rises and/or spending restraint at a time when the economy is already weak,” said Gregory at Capital Economics.
What other options are there?
The chancellor is aiming to focus on a “pro-growth” narrative in the coming weeks, and a quicker economic expansion would pay dividends in terms of the public finances.
Reeves is this week gearing up for a trip to China as she seeks ways of boosting the economy.
But hopes for a strong turnaround in GDP growth could easily be confounded. With the declines in government bond prices intensifying, investors have warned that attempts to lay a strong fiscal foundation for the current parliament are in jeopardy.
Reeves “has no room left, given that the sell-off has been relentless since October”, said Pooja Kumra, a UK rates strategist at TD Securities.
Data visualisation by Keith Fray
https://www.ft.com/content/ca4cab92-2596-49a4-9f73-f1f6d10a041e
