Government still at risk of breaking fiscal rules despite market recovery from January jitters

Higher interest rates and a weaker economic outlook could force the Chancellor to choose between fresh policy-tightening measures on 26^th March, or breaking the fiscal rules she set only last October, despite markets recovering after their January jitters, according to new research published today (Thursday) by the Resolution Foundation.

The Foundation’s latest Macroeconomic Policy Outlook examines what has been driving market volatility and bad economic news since the Budget, and what it means for both households and the public finances.

The authors note that recent market volatility saw Government 10-year gilt yields rise to a peak of around 4.9 per cent in mid-January, their highest level since July 2008, and around 0.75 percentage points above the level assumed by the OBR at the Autumn Budget. This, combined with falls in sterling, led to uncomfortable comparisons with Liz Truss’s ill-fated ‘mini-Budget’.

The report notes that while the increase in UK gilt yields was primarily driven by international factors – indeed US Treasury yields rose by more than those for gilts over the same period – the January jitters in the market nonetheless showed that the UK is particularly sensitive to volatility in the global economy.

While 10-year gilt yields have fallen in recent weeks, they remain 0.5 percentage points above the level forecast by the OBR last Autumn. Should they remain at this level, UK debt-servicing costs would increase by around £7 billion a year.

And, while shorter-term expectations of changes in the Bank of England’s policy rates have risen by less, expectations over the next five years are up by around 0.5 percentage points on average, compared to the outlook at the time of the Autumn Budget.

These rates are important for the pricing of mortgages and the Foundation finds that the 570,000 households that are due to roll-off five-year fixed rate mortgages in 2025 are set to see their annual costs rise by £2,700 a year, on average. That’s £280 higher than if rates evolved in line with the OBR’s forecast.

With the Chancellor leaving just £10 billion of headroom against her fiscal rule of balancing day-to-day public spending and tax receipts by the fifth year of the forecast, and with the wider economic outlook still uncertain, the chance of the Government falling foul of its fiscal rules remains on a knife edge.

The report concludes that, should the OBR leave the Chancellor at risk of breaking her fiscal rules on 26^th March, she will need to announce fresh fiscal tightening to meet them, or risk further market jitters. The Foundation adds that the weaker economic outlook may leave the Bank able to cut interest rates faster than markets currently expect.

James Smith, Research Director at the Resolution Foundation, said:

“In her Budget last Autumn, the Chancellor set out new fiscal rules but left herself very little wiggle room against breaking them.

“Market volatility since the Budget has put the public finances under pressure, with higher gilt yields adding £7 billion to debt servicing costs. While other factors will also affect the OBR’s forecast, the chance of the Chancellor falling foul of her fiscal rules remains on a knife edge.

“Having set out these rules only last Autumn, and repeatedly re-committed to them in recent weeks, the Chancellor will have to meet them on 26^th March or risk further market jitters.

“While the Chancellor is rightly focused on fleshing out her long-term strategy for economic growth, tough short-term decisions, including fresh tax rises or spending cuts, may also be needed in the coming weeks to demonstrate her commitment to sustainable public finances.”