Economists have warned that Rachel Reeves is close to breaking her fiscal rules, which could lead to more tax increases, as borrowing costs reach their highest point since 1998.
The Chancellor only has £1billion left in her budget before she faces a tough choice—raising taxes, cutting spending, or breaking her main rule of balancing the budget by the end of this Parliament, Capital Economics has revealed.
The rise in borrowing costs has almost completely used up the Chancellor’s financial cushion, wiping out £8.9billion of her £9.9billion headroom.
Economists Ruth Gregory and Alex Kerr said: “There is a significant chance that the Office for Budget Responsibility (OBR) will judge that the Chancellor, Rachel Reeves, is on course to miss her main fiscal rule when it revises its forecasts on March 26.”
The analysts noted that fiscal headroom “has never been this low” in recent years.
The analysts noted that fiscal headroom “has never been this low” in recent yearscts
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They cautioned that just a 0.06 percentage point increase in market interest rates would completely eliminate the remaining headroom.
They added: “It would only take a further 0.06 percentage point increase in market interest rate expectations and 20-year gilt yields to wipe it out altogether.”
Capital Economics said that this is before the OBR factors in the recent weakness in economic activity.
It said: “Reeves will be in trouble if the OBR decides that some of the weak GDP growth in Q3 and Q4 of last year reflects a permanent, rather than a temporary, loss of output. It would take just a 0.1pc downward revision to the OBR’s forecast in 2029/30 to wipe out that £1.0bn of headroom.
“This means 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.
“We suspect she would choose the latter, perhaps by reducing spending relative to existing plans in 2028/29 and 2029/30. That way, she could avoid worsening the economy’s near-term prospects and avoid politically unpalatable tax rises. And she may hope that by the time the spending squeeze arrived, things had improved such that she would not actually have to implement it.”
Market analysts have also raised concerns about “stagflation” as inflation remains persistent while growth stalls.
Sunaina Sinha Haldea of Raymond James told the BBC that markets view this situation “very poorly” as it limits the Bank of England’s options.
She said: “There’s no impetus to spur the economy into a growth mode. And markets are concerned that will absolutely cost the UK in terms of its economic outlook.
“The mood music around the UK is different this time around… Certainly this time around the concern is more dire and the mood is darker.”
The Bank of England is now expected to cut rates only twice in 2025, compared to earlier expectations of six reductions.
A Treasury spokesman responded to the fiscal pressure, stating: “No one should be under any doubt of the Chancellor’s commitment to economic stability and sound public finances. That is why meeting the fiscal rules is non-negotiable.”
The spokesman emphasised that Reeves “would not repeat the likes of October Budget and is now focused on rooting out waste in public spending through the Spending Review and growing the economy”.
The UK’s long-term Government borrowing costs have surged to their highest level since 1998, dealing a potentially significant blow to Chancellor Rachel Reeves’s fiscal plans.
The yield on 30-year gilts climbed to 5.22 per cent on Tuesday, surpassing last year’s peak and intensifying pressure on the Treasury. The sharp increase threatens to squeeze the Government’s headroom for public spending as interest costs rise.
The pressure on the Treasury’s purse-strings also impacted the housing market, with Halifax reporting the first drop in average house prices in nine months during December.
Mortgage rates have risen to an average of 5.47 per cent for a two-year fixed deal, further challenging home affordability.