Borrowing costs have surged in the wake of Rachel Reeves’s maiden Budget – JOHN THYS/AFP
Rachel Reeves is at risk of breaking spending rules she set just two months ago as her record tax raid pushes up Britain’s borrowing costs and reignites inflation fears.
Economists said two-thirds of the Chancellor’s £9.9bn borrowing buffer set in the October Budget had already been wiped out by higher UK gilt rates and expectations that the Bank of England will keep interest rates higher for longer.
Capital Economics estimates Ms Reeves’s headroom has been cut to just £3.5bn based on current market pricing, suggesting any further lurch upwards could force her to raise taxes or slash spending as soon as March.
The Chancellor left herself a wafer-thin buffer to meet a new rule that requires her to bring day-to-day spending back into balance within three years.
The Office for Budget Responsibility (OBR), the Government’s tax and spending watchdog, had assumed that the Bank’s base rate – which is used by high street lenders to price mortgage and savings products – would average roughly 3.6pc until the end of the decade, down from the current rate of 4.75pc.
Market pricing now implies interest rates will remain above 4pc for much of the next three years, with just two cuts priced in for 2025.
Capital Economics also said 20-year gilt yields, on which the OBR bases its long-term rate forecast, have also climbed since the Budget, hitting 5.09pc on Tuesday.
Concerns about inflation, which currently stands at 2.6pc and could rise to 3pc next year, have left investors nervous about UK debt.
It came as the world’s biggest bank said it was shunning gilts amid fears that Ms Reeves has stoked inflation with record increases in the minimum wage and her £25bn increase in National Insurance.
JP Morgan Asset Management, which has $3.3 trillion of assets under management, including more than $750bn in bonds, said “big uncertainty” over the magnitude of next year’s wage increases and the impact on prices meant it was steering clear of UK gilts.
Seamus MacGorain, a managing director at the bank, said it was buying Spanish and Italian debt instead.
“I think there’s a big uncertainty [about the UK]. We had a period of very high inflation, mainly due to energy prices. And that inflation passed through prices all around the economy, including service prices and wages.
And now we’ve had a year where energy prices are a bit lower. What should happen is that next year, all these other prices, like services, wages, should come down. And if they do, then I think the UK is quite an attractive market, [but] there’s still a bit of uncertainty about whether that will happen.”
He added: “We think the valuation is there, but we’re not seeing enough progress on inflation yet.”
The Bank of England warned this month that employers were increasingly responding to the Chancellor’s £25bn increase in employer National Insurance contributions by raising prices, signalling that interest rates may remain higher for longer to prevent the economy from overheating.
Officials are watching pay closely to determine whether increases next April – including a record rise in the minimum wage for younger workers – will stoke a fresh wave of price rises.
Roughly 40pc of pay deals are negotiated in April, according to the Bank, which is the same month when increases in the statutory minimum also take effect.
Pantheon Macroeconomics believes inflation is already on course to hit 3.1pc next Aprilamid higher energy bills and as “more tax hikes and government-set price rises add to measured inflation”.
Mr MacGorain said developments next spring could determine whether the bank started buying gilts again. He said: “The spring of next year is quite important, because a lot of prices in the UK reset on a fiscal year-end basis. I think that will be the moment when we see if inflation is going to come down in the UK like it has in other places, or whether it’s going to be a bit more persistent.”
The Government announced in October that the minimum wage will rise by 6.7pc next April to £12.21. For 18, 19 and 20-year-olds, the increase will be much steeper, with the current rate of £8.60 rising to £10 an hour – an increase of 16pc year-on-year.
That is the largest rise on record and comes as the Government prepares to unleash a wave of workers’ rights reforms that employers say will exacerbate Britain’s worklessness crisis.
The Bank held rates at 4.75pc in December. Investors now expect Threadneedle Street to cut rates just twice in 2025, compared with at least four times ahead of Ms Reeves’s maiden Budget. The Bank cut rates twice in 2024. By contrast, the European Central Bank cut rates four times while the US Federal Reserve reduced rates three times.
Mr MacGorain said: “Other central banks have been easing policy more quickly than the Bank of England, and that makes sense, because they’ve seen a bit more progress on inflation. If we did see wages quite a bit lower in the UK in the spring of next year, and then service inflation falling then the Bank will accelerate rate cuts, and gilts will do very well. But for now, the bank has been quite cautious, and we think that’s appropriate.”
