Less than three months after delivering her first Budget, Rachel Reeves faces treacherous financial waters, as rising UK borrowing costs erode her room for manoeuvre.
There is now a real risk that the Chancellor will have to impose tougher fiscal policy in March, when the Office for Budget Responsibility presents its forecasts, as she seeks to meet self-imposed budget constraints.
The situation is devastating for the Labor government in light of Reeves' claims that October is hers Financial statement This was a historic effort to 'erase everything' when it comes to the UK's budget problems.
How did the UK get off track?
The central problem is fixed It rises in government borrowing costs, in the UK and around the world. The United States has been a major factor in the global bond sell-off 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 particularly hard hit by fund managers' concerns that… economy It could enter a period of “stagflation,” as persistent price pressures prevent the Bank of England from cutting interest rates to boost them.
Combined with a rise in debt sales expected after the Budget, fear of stagflation has helped push the UK's 10-year borrowing costs to their highest level since the 2008 global financial crisis and 30-year borrowing costs to their highest levels this century. It has also sparked bouts of weakness for the pound.
“The combination of pressure on both government bonds and the currency suggests the market is concerned about a UK recession or financial event,” said Jim McCormick, macro strategist at investment bank Citi.
Why is this so harmful?
The rising cost of borrowing has direct consequences for Reeves' budget plans, through increased interest payments that already exceed £100bn a year.
It has set itself the goal of balancing the current budget, excluding investment spending, by 2029-2030. As indicated by the forecasts for October from the Office for Budget Responsibility, the Financial Regulatory Authority Reeves It will meet the rule with a margin of £9.9bn to spare that year.
But rising interest costs put their target at risk. Yields on longer-term bonds have risen steadily in recent weeks, with the 10-year bond yield rising to 4.82 percent on Wednesday, the highest level since 2008.
Ruth Gregory, an economist at consultancy Capital Economics, said the moves seen so far would be enough to more than erase progress against the current budget base, with the Treasury now on track to break the base by around £1 billion.
This estimate is derived from implied market expectations for the Bank of England's benchmark interest rate and the 20-year government bond yield.
“No one should be in any doubt that adherence to fiscal rules is non-negotiable and that the government will maintain an iron grip on public finances,” the Treasury said on Wednesday. “Only OMB forecasts can accurately predict the extent of the government's progress; anything else is pure speculation.”
Are there other factors affecting public finances?
The OBR forecast due out on March 26 will also set out a revised view of growth, which also has a major impact on public finances. GDP readings at the end of last year were weaker than expected and the Bank of England estimates that the economy failed to grow in the last three months of 2024.
Analysts said the weak data made the Office of Budget Control's October forecast for economic growth of 2 percent in 2025 look weak.
But the impact of GDP movements on borrowing depends on whether the Office for Budget Responsibility sees the economy as capable of recovering and making up the shortfall later in parliament, or whether it decides there is a permanent loss in output.
The Office for Budget Responsibility downgrading its view on the UK's potential productivity and growth would represent a further blow to the Treasury and public finances.
What can Reeves do?
The deterioration in the UK's fiscal outlook comes as the government prepares for the next stage of its multi-year spending review, the results of which are expected in June.
The Treasury set out total spending by Whitehall departments in the October Budget, with day-to-day spending set to rise by 3.1 per cent in 2025-26 before falling sharply to 1.3 per cent real growth in 2026-27.
Detailed plans have been drawn up for the first year. The spending review now looks to subsequent years. Officials have He pointed out If Reeves needs to make a fiscal policy correction this spring, it will likely come through tougher spending plans rather than early tax hikes.
That's because she has pledged to hold only one “fiscal event” each year, which would be the time to change taxes and won't be held until the fall.
Ben Zaranko, an aide, said restoring progress back to October levels of just under £10bn through tougher spending plans would mean limiting real growth in day-to-day administrative spending from 1.3 per cent a year to just under 1 per cent. Director of the Institute of Financial Studies.
But analysts fear that if the bond market sell-off continues, Reeves may have to go further in an attempt to bolster financial credibility. Such action would entail raising taxes and direct spending control, not just pledges of greater discipline late in parliament.
“Reeves may soon face a bad choice of flouting her fiscal rules or announcing further tax increases and/or spending restraint at a time when the economy is already weak,” said Gregory of Capital Economics.
What other options are there?
The Chancellor aims to focus on the “pro-growth” narrative in the coming weeks, and that faster economic expansion would pay dividends in terms of public finances.
This week, Reeves is preparing for a trip to China, where she is looking for ways to boost the economy.
But hopes for a strong turnaround in GDP growth could easily be dashed. As the decline in government bond prices intensifies, investors have warned that attempts to establish a strong financial foundation for the current parliament are at risk.
Reeves “has no room left, given that the selling has been relentless since October,” said Pooja Kumra, UK interest rates strategist at TD Securities.
Data visualization by Keith Fry
