Less than three months after making her first Budget, Rachel Reeves is running into financial trouble as rising borrowing costs in the UK destroy her room to move forward.
There is now a real risk that the chancellor will be forced to impose tighter monetary policy as soon as March, when the Office for Budget Responsibility presents its forecasts, as it tries to meet its budget constraints.
The situation is hurting the Labor government because of Reeves' claims that his October financial statement marked a significant attempt to “wipe the slate clean” when it comes to the UK's budget problems.
How did the UK mature?
The main problem is sustainability height on government borrowing costs, in the UK and internationally. The US has been at the center of global bond sales in recent months, driven in part by expectations that tariffs imposed by US president-elect Donald Trump will fuel inflation.
But the UK has been hit hard by fund managers' worries that the economy it may enter a period of “stagflation”, where persistent price pressures prevent the Bank of England from cutting interest rates in order to boost growth.
Combined with an expected post-Budget credit market surge, inflation fears have helped send UK 10-year borrowing costs to their highest level since the 2008 global financial crisis and 30-year borrowing costs to their highest this century. It also caused weakness in sterling.
“The mix of pressure on both gilts and cash shows that the market is getting worried about a UK recession or financial crisis,” said Jim McCormick, senior analyst at investment bank Citi.
Why is this so dangerous?
The high cost of borrowing has a direct impact on Reeves' budget plans, driving interest payments up to more than £100bn a year.
He has set himself the goal of balancing the current budget, excluding capital expenditure, by 2029-30. An October estimate from the Office for Budget Responsibility, a fiscal watchdog, suggested Reeves it would meet the criteria with £9.9bn of margin to be maintained that year.
But high interest rates put his goals at risk. Yields on long-term gilts have risen steadily in recent weeks, with the 10-year gilt yield rising to 4.82 percent on Wednesday, the highest since 2008.
Ruth Gregory, an economist at consultancy Capital Economics, said the moves seen so far would be more than enough to clear headroom against the current budget policy, with the Treasury now on track to breach the rule by around £1bn.
These estimates are derived from market-linked expectations of BoE interest rates and 20-year yields.
“No one should be in any doubt that meeting the financial rules is non-negotiable and the government will hold a tight rein on the public purse,” the Treasury said on Wednesday. “It's the only OBR forecast that can accurately predict how much headroom the government has – anything else is pure speculation.”
Are there other factors that affect government finances?
The OBR's forecast due on 26 March will present an updated outlook for growth, which will also make a significant contribution to government finances. GDP readings at the end of last year were weaker than expected and the BoE predicts that the economy will fail to grow in the last three months of 2024.
The poor data makes the OBR's forecast for economic growth of 2 per cent in 2025 look vulnerable, analysts say.
But the effect of GDP movements on borrowing depends on whether the OBR judges the economy could go back and make a default later in parliament, or if it decides there is a permanent loss of output.
The OBR's downgrade in its outlook for UK output and potential growth would represent a further blow to the Treasury and public finances.
What can Reeves do?
The deterioration in UK financial prospects comes as the government prepares for the next phase of a multi-year spending review, the results of which are expected in June.
The Treasury set out the Whitehall department's spending envelope in the October Budget, with daily spending due to rise by 3.1 per cent in 2025-26 before falling sharply to 1.3 per cent growth in real terms from 2026-27.
Detailed plans for the first year are laid out; The expenditure review now looks at the following years. The officers went has been demonstrated that if Reeves has to make adjustments to monetary policy this spring, it will come with tighter spending plans rather than immediate tax increases.
This is because he has pledged to hold only one “money event” every year, which will be around the time of the tax change and won't be held until the autumn.
Restoring headroom to its October levels of just under £10bn through austerity spending plans would mean reducing real-world growth in day-to-day department spending from 1.3 per cent a year to less than 1 per cent, said Ben Zaranko, partner. director of the Center for Financial Studies.
But analysts fear that if the bond sales continue, Reeves could be forced to step up efforts to shore up financial confidence. Such action could include tax hikes and spending cuts, not just vows of good behavior late in parliament.
“Reeves could face the stark choice of breaking his fiscal rules or announcing more tax hikes and/or spending cuts at a time when the economy is already weak,” Gregory told Capital Economics.
What alternatives are there?
The chancellor intends to focus on the “growth” report in the coming weeks, and the rapid economic expansion will pay dividends in terms of government finances.
Reeves is this week preparing for a trip to China as he looks for ways to boost the economy.
But prospects for a strong turnaround in GDP growth can be easily confounded. With government bond prices falling further, investors have warned that efforts to put a solid foundation for the current parliament's finances are in jeopardy.
Reeves “doesn't have much room left, given that sales have been flat since October”, said Pooja Kumra, UK valuation specialist at TD Securities.
Data visualization by Keith Fray