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UK Budget, UK Economy

Gilt yields on the rise – what does it mean?

In the last week or so, the main set of economic and fiscal news has been the increase in market interest rates on gilts – the UK Government’s bonds.

My first manager once warned me – quite rightly – about the tendency to overinterpret market movements, calling it ‘financial entertainment.’ But over a week of movement in one direction is pretty hard to ignore, and it is the harder for the Chancellor because she left herself so little room to manoeuvre in order to meet her fiscal rules – themselves already pretty loose.

Squeezing every drop of newly found headroom

When Rachel Reeves presented her first Budget, many of were surprised at just how much of the additional headroom found from changing the fiscal rules was used up in one go. There had been briefings of policy eating away at just £20 billion of the new headroom; it turned out to be more like £33 billion.

And that is despite very meagre growth in real-terms government spending beyond 2025-26. It was essentially a one-off boost in spending in 2024-25 and 2025-26, designed to change the level of government spending but not its future growth trajectory.

The Chancellor, then, was walking a tightrope: betting that a short-term fiscal impulse would lead to immediate macroeconomic and public services improvements, maximising the additional borrowing she could get away with while complying with rules that were significantly less stringent than the ones she inherited from Jeremy Hunt.

In fact, as the chart below shows, the October 2024 Budget was the fiscal event with the third-lowest headroom since the OBR was formed: less than £10 billion, or 0.3% of GDP. It’s about a third of the historical average headroom, and well below the £95 billion average forecast error in the current budget when five years out. In short, the headroom is essentially nil – and that’s against the current budget rule, for which headroom was over £14 billion in March 2024. Jeremy Hunt’s (also-not-that-stringent) debt falling rule was broken in October by £6 billion.

Chart 1: Headroom against fiscal rules at successive forecasts

Chart showing this is the third-lowest budget headroom since the OBR was created in 2010

Source: OBR. Values used are percentages of GDP at the time of the forecast multiplied by 2029-30 GDP for comparability purposes.

The fiscal adjustment conundrum

With such little buffer in the central OBR scenario – and given that the UK’s debt stock is around 100% of GDP, and therefore even small changes in the effective interest rate increases interest payment significantly – it’s unsurprising that the UK Government has found itself in a tricky position after a (relatively minor) negative shock.

The OBR publishes a handy ready-reckoner for the effect of interest rate changes on the cost of servicing debt. Since they took market determinants, long-term market interest rates have risen by just over 1 percentage point, which would cost over £12 billion extra in spending in 2029-30 (the target year for the fiscal rules). Keen observers will note that is enough to wipe out the headroom on the current budget, and the damage is even worse on net financial liabilities, as there is higher borrowing in every year.

We wrote at length in the Autumn about the fact that recent Chancellors appear to be much more willing to take high-risk approaches to the public finances, where they leave themselves little room for manoeuvre if things go wrong. But we also talked about the bind that the current institutional framework puts Chancellors in, to the extent that they feel unable to say they won’t meet them – even if it’s to the detriment of economic outcomes. Sadly, we seem to already be at that stage, with the Prime Minister stating the Treasury will be ‘ruthless’ in cutting during the Spending Review.

Of course, the Treasury doesn’t have to cut spending – it could well raise taxes, or take a gamble on market participants having the appetite to fund more borrowing than anticipated. But regardless of the merits of each (or a combined) approach, the Chancellor boxed herself in when she stated there would be no more tax rises or borrowing at the CBI Conference. It doesn’t take much to figure out that if that line were followed, spending would have to take the slack.

There are significant questions about the political deliverability of significant spending cuts – even if they are only against plans. The Chancellor stood up in the Commons less than three months ago to lay out an argument that public services were in need of repair – hence the need for spending increases of £30 billion a year over and above the tax rises included in the Budget. It would seem odd to make the opposing argument so soon afterwards.

I wouldn’t start from here

This is by no means as bad a situation, but it reminds me of Sir Charlie Bean, who, when asked about what the best course of action available to the Liz Truss government after the market meltdown, quipped that getting a Tardis might not be such a bad idea.

As countless ministers of finance across the world have found before, Rachel Reeves might quickly find out that the ideal scenario – not having to tighten fiscal policy – is not available to her, either politically or financially. The market’s appetite for lending the money for additional borrowing is clearly dwindling. So she might have to preside over a draconian spending review, or else break the Labour Party’s manifesto pledges on taxes. None of the options are particularly appealing.

Is tightening the right thing to do? That might well be a moot point if there is no alternative, but it doesn’t mean that it doesn’t have costs. In the OBR’s forecast, GDP was boosted in the short-run by the additional government spending announced at the Budget; it therefore stands to reason that a tightening fiscal statement on 26 March would be accompanied by a downgrade in GDP.

This is far from ideal – the consensus among macroeconomists of nearly all persuasions is that policy should be countercyclical. But with output stuttering in the past few months, it runs the risk of aggravating the economic situation. One of the ways that quickly manifests itself is in lower tax receipts than otherwise would be the case – therefore worsening the borrowing situation. It’s a well-worn story in emerging markets, and one that Britain would do well to avoid. But we are where we are.

One policy decision worth looking out for is whether Rachel Reeves chooses to move some of the £20 billion a year increase in capital spending to the resource side of the ledger. This endlessly popular move by successive Chancellors is often portrayed as ‘protecting frontline services’, but it is a large part of the story why the UK’s capital stock has been eroded over time and why its productivity growth has lagged since the financial crisis. The OBR included an increase in GDP in response to the increase in public investment, and an effect beyond the medium-term forecast that will have improved the outlook for public finance sustainability. Moving away from these long-term policies would be damaging to medium-term, but even more so long-term growth, and it’s hard to see how it would be compatible with the Prime Minister’s stated aim of ‘fixing the foundations.’

Authors

João is Deputy Director and Senior Knowledge Exchange Fellow at the Fraser of Allander Institute. Previously, he was a Senior Fiscal Analyst at the Office for Budget Responsibility, where he led on analysis of long-term sustainability of the UK's public finances and on the effect of economic developments and fiscal policy on the UK's medium-term outlook.