The UK government has come under pressure from a bond market sell-off and the tumbling pound, heaping pressure on the chancellor, Rachel Reeves, to reassure investors about Britain’s economic and financial position.
After a challenging first six months in power for the government, the chancellor’s options have been limited by Labour’s political promises. There are a range of measures, of varying severity, the Treasury and the Bank of England could still take, depending on how market conditions unfold.
Do nothing
Reeves could yet catch a lucky break. Some City analysts believe financial markets have overreacted to the challenging economic and fiscal outlook. Donald Trump’s bite may prove less aggressive than his bark.
The Office for Budget Responsibility (OBR) has yet to capture the financial market data used in its forecasts and will do so closer to 26 March – leaving time for conditions to subside.
Financial markets are pricing in two quarter-point interest rate cuts from the Bank of England this year. However, many analysts expect a weaker economic outlook could lead Threadneedle Street to cut borrowing costs four times in 2025.
However, the situation could become more challenging after Trump’s inauguration on 20 January, should he take rapid action to announce sweeping import tariffs, which could in turn lead to surging inflation.
“A lot will depend on what materialises on or around 20 January,” said Mohamed El-Erian, a former International Monetary Fund deputy director who is now the president of Queens’ College, Cambridge.
Spending cuts
The Treasury has signalled that spending cuts would be most likely to ensure it does not break its fiscal rules. However, that raises challenges for Labour, having promised there would be no return to austerity, and to fix public services.
If the OBR’s spring forecasts indicate a breach of fiscal rules, cuts to capital spending, on everything from new roads to railways, seem most likely, Morgan Stanley’s chief UK economist, Bruna Skarica, said. Last autumn, the government outlined plans to increase investment in areas such as transport and housing by £100bn over the next five years. This would, however, undermine Labour’s plan to use higher investment to help kickstart long-term economic growth.
Another option is to commit to steep spending cuts beyond the current spending review period and spend more in the short term. Reeves had set out plans for day-to-day spending to rise by 4.3% this year and 2.6% next year, then by just 1.3% each year thereafter. At that level, the Institute for Fiscal Studies said it expected there would “almost certainly” be real-terms cuts for some departments. A tighter settlement still could therefore be politically challenging.
The former Bank of England policymaker Martin Weale, a professor of economics at King’s College London, said public spending cuts would be “the least bad solution”.
Tax increases
The key question is whether rising gilt yields will see the UK breach its fiscal rules when the OBR publishes its updated forecasts on 26 March, alongside Reeves’ spring statement.
One option is to raise taxes again, but businesses are already up in arms about the increase in national insurance costs after Reeves’ decision to raise taxes by £40bn in her October budget.
El-Erian said that VAT and income tax rises could be the best options. “Especially income tax on the rich. But she has ruled out any further tax increases,” he said.
“I said this during the campaign that ruling out VAT and income tax was over-constraining yourself at the time when you inherit a very difficult fiscal situation. This is before we realised how bad the inheritance was.”
Ashley Webb, a UK economist at the consultancy Capital Economics, said Reeves had several options: U-turning on her tax promises, creating new levies, tweaking existing plans, or raising taxes in areas she has not ruled out. This could include capital gains tax, alcohol and tobacco duties, air passenger duty, vehicle excise duty and property taxes.
Rate cuts
The Bank could help to restore calm by signalling readiness to cut interest rates. Financial markets currently expect two reductions to 4.25% this year – far fewer than some investors had been expecting last year.
The next meeting of the Bank’s rate-setting committee is scheduled for 6 February.
A sign that the Bank is willing to reduce borrowing costs at a faster pace than current expectations could ease the gilt market sell-off.
The Bank’s decision could be influenced by the latest market movements. Rising government borrowing costs will weigh on the economy – making cuts more likely. But a weaker pound could drive up inflation and make the central bank more reluctant.
In extremis, the Bank could opt for an emergency, unscheduled rate cut. But this could cause more harm than good, by fuelling panic.
The last time it did so was during the frantic first weeks of the Covid pandemic spreading to Britain in early 2020. Speaking on Thursday, the Bank’s deputy governor for financial stability, Sarah Breeden, who is a member of the rate-setting monetary policy committee, doused concerns over the bond market.
“We have a dashboard; we’re monitoring it. So far the moves have been orderly; we’ll continue to watch this space. So far, so good,” she said.
She also reiterated a commitment to gradual interest rate cuts. “Bank rate will be coming down. The question is the pace at which it comes down. And we will only know that as the data evolves.”
Bank of England emergency intervention
After Liz Truss’s September 2022 mini-budget triggered a meltdown in the bond market, Threadneedle Street intervened by pledging to buy up to £65bn of UK government bonds to ease pressure on pension funds.
Though comparisons to Truss’s ill-fated premiership have been raised, City analysts said a similar intervention currently looked unlikely.
“This is not a Liz Truss moment,” said El-Erian. “The reason is the journey matters: the Liz Truss moment was defined by a very disorderly increase in yields. That caused damage elsewhere. This time around it hasn’t been that.”
Although at historic levels, the rise in gilt yields has been slower, taking several months to be reached. In comparison, analysts point out that of the top 10 biggest daily moves in the gilt market in the past three decades, nine came in 2022.
Darren Jones, the chief secretary to the Treasury, said on Thursday that gilt markets were orderly, suggesting no need for emergency measures. His comments appear to have calmed bond markets, at least for now.
Chris Turner, the global head of markets at ING, said: “We don’t think the Bank of England is ready to do that yet, since the gilt sell-off is not as acute as it was in 2022.”
Weale said: “Over the Truss episode, the Bank was concerned about the doom loop affecting pension funds. They have since reduced their exposure to the risks associated with rising long rates.
“I think the Bank would refuse to buy in government stock just to bring long rates down; markets would react very badly to that and sterling would probably fall sharply,” he said.
“My advice at the moment would be to do nothing,” he added, waiting until the OBR’s latest economic forecasts in March.
