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Labour’s first budget was supposed to end 14 years of austerity without inducing the kind of shock associated with Liz Truss. Yet within months, Rachel Reeves’s mix of spending increases, higher taxes on business and extra borrowing for investment has begun to unravel.
Not so much in response to the bond market jitters of last week, when panicky traders raised the cost of government borrowing to a level not seen since the financial crash a decade and a half ago – this reaction was sparked in part by a lack of confidence in Donald Trump’s economic plans and could prove short-lived. The unravelling relates more to domestic issues and how Reeves, when she delivers her next financial statement in March, will be forced to admit that the financial leeway she gave herself in October has gone.
The chancellor reluctantly gambled, as all chancellors must, that she could make progress without being blown off course by events. With a buffer of about £10bn on a budget of more than £1tn, staying on course was always unlikely.
There was a risk that a rebound in inflation, however modest, would force the Bank of England to keep interest rates higher for longer. There would be little slack in the budget if that happened. Now it seems Reeves – without ripping up the self-imposed constraining rules that are the backbone of her strategy – will need to ask for more tax increases or higher borrowing to avoid reneging on public spending commitments.
Hitting the budget sweet spot is proving difficult in all major economies. Too many tax rises and the economy falters. Too much borrowing when inflation and interest rates are higher than expected and international lenders get jumpy.
Some of the UK’s issues are of its own making. Reeves clawed back the Conservatives’ £20bn national insurance giveaway to households by lumping the bill on business, which has delayed much needed private sector investment and stifled growth.
Figures for almost every sector of the economy as we enter 2025 make for grim reading. “Stagnation” is the word most often used to describe the manufacturing and services industries, consumers are reluctant to spend and the jobs market is faltering. Worse, there could be a temporary spillover into higher inflation as firms charge more for their goods and services to compensate for a higher national insurance charge.
The pointed message from high street retailer Next, that the price of its clothes will rise by another 1% over the coming year, adds to the sense that Reeves underestimated the consequences of relying on business to pay much of the budget bill.
Inflation, though, is the consequence of broader forces, which is why all major economies are struggling to achieve targets of about 2%.
Panic selling in the bond market last week, triggered by fears that Trump will cut taxes and impose tariffs on US imports – both inciting another bout of inflation – sent the interest rate on US bonds soaring and the UK followed suit.
Reeves was hoping the cost of borrowing would fall over the next year to below 4% from the current 4.75%. It looks like the full extent of the drop will be delayed until 2026.
What should the chancellor’s reaction be? Critics say budget rules imposed by Reeves are too tight and they should be loosened, allowing for more borrowing. If the economy is to bounce back, cuts to public spending or higher taxes will only delay the rebound.
Reeves fears the financial market response would lead to even higher borrowing costs, forcing the government to make even larger spending cuts. These are difficult issues to navigate, with few right answers. An uncomfortable position for a chancellor who resists gambling and yet faces risks at every turn.
