Turbulent times

Turbulent gilt markets, a devaluing pound and speculation about the Office for Budget Responsibility (OBR) downgrading its economic forecasts is not the start to 2025 the Chancellor was hoping for. What is causing all the fuss? On 9 January, the UK 10-year gilt yield closed at 4.8 per cent, up from 4.58 per cent just a week before. Since the beginning of December, UK bond yields have trailed a similar rise in US 10-year Government bonds.

These are not large changes. But the main reason so much attention is placed on them is that the Chancellor set out plans last autumn for how she would meet her fiscal rules, but did so by a very small margin of error (or headroom). In particular, the OBR forecast gave the Government just £10 billion of breathing space against its binding fiscal rule to balance day-to-day spending with taxes in 2029-30. For context, that level of headroom was just over a third of the average headroom held by Chancellors since 2010.

The OBR also pointed out that a one percentage point increase in interest rates could add up to £17 billion to debt interest costs by 2029-30. So, with interest rates now sitting around 0.7 percentage points higher than in the OBR’s Autumn forecasts, there’s a serious risk this rule may be broken when the OBR publishes its next forecast on the 26 March.

That said, there still remains significant uncertainty around whether we’ll see this risk crystallise, with the OBR unlikely to take final market data for its forecast for several weeks, during which borrowing costs could recede. And there is no sense that the Chancellor is, as yet, facing a fiscal emergency that requires immediate intervention (in contrast to the sharp spike in bond yields and resulting market disruption back in 2022). The economic levers that determine the fiscal position may have shifted to place the Government slightly more in the red than they expected in Autumn 2024 Budget, but there are currently no significant impacts on the Government’s ability to borrow (even if that borrowing has become more costly), nor any spillover effects on the financial system of the kind we saw after the Truss-Kwarteng mini-Budget.

But it remains the case that the Chancellor is at risk of breaking her fiscal rules on 26 March. So what she should do, and when? Here are five options, none of which are easy or politically pain-free…

• Do nothing, and wait for the Autumn 2025 Budget

The Chancellor has committed to holding just one Budget per year, but chose to stick with the previous Government’s regime of twice-yearly OBR forecasts. This has left her in an unenviable position. Currently, she is at risk of having an OBR forecast published on 26 March that announces the plans set out in Autumn Budget 2024 are not consistent with her fiscal rules, but with no opportunity to address this until the Autumn 2025 Budget. This might be a politically painful position given the Government’s insistence that “meeting the fiscal rules is non-negotiable” – and puts pressure on the Chancellor to turn the OBR’s Spring forecast into a full-blown fiscal event, allowing her to make policy changes.

However, while there may be political reasons to hold an emergency Budget to show that the Government was meeting its fiscal rules, it would be suboptimal from an economic and fiscal perspective. ‘Wait for the Autumn Budget’ is arguably the best option open to the Chancellor, at least based on current conditions. Why should she attempt to weather the bad news until the Autumn? Borrowing costs have reached historic highs, but making frequent policy changes in reaction to movements in the bond market runs the risk of taking permanent and concrete policy decisions with real-life impacts on households in reaction to bond market movements that may turn out to be temporary.

Figure 1: Don’t panic – UK gilt yields track global markets

• (More) tax hikes

If the Chancellor does choose to act before the Autumn, or if the weaker fiscal outlook continues through to then, she would need to raise taxes or reduce current spending so as to close the current deficit. For the first of these, the challenge is primarily a political one. Having promised that the Government was “not coming back with […] more taxes” following the £40 billion tax rises announced in the Autumn, it may be politically difficult for the Chancellor to announce further tax hikes just five or even twelve months later. But, putting the optics to one side, there are still clear opportunities for raising taxes in ways which could contribute to a more efficient and productive economy. One substantial option would be to get the ball rolling on overhauling electric vehicle taxation given widespread acknowledgement that this will be necessary in some form, sooner or later, given the loss of Fuel Duty revenue from planned electrification. Our estimates suggest this could raise as much as £8 billion by 2029-30 but make an even greater contribution to fiscal sustainability in the longer-run.

Figure 2: Fuel Duty revenue losses are inevitable over the coming years

• Cut public services spending (even further)

If tax rises seem unpalatable, the alternative to closing the current deficit is to cut departmental spending limits (RDEL) from the plans set out in the Autumn 2024 Budget.

Spending allocations for departments in 2025-26 were set in the Autumn 2024 Budget and it would be very unusual to cut those so late in the day. But three years of departmental budget allocations will need to be set at the 2025 Spending Review in June. To avoid breaching her fiscal rules, the Chancellor could announce in March that she is cutting the RDEL envelope (currently set for 1.3% real growth) for 2025-26 to 2029-30, and leave until the Spending Review the decision on which specific departments would bear these cuts.[1]

We can make some educated guesses of which departments might be on the chopping block. Given the pressures and political focus on the NHS and schools, alongside Britain’s NATO commitments on defence, it seems inevitable that ‘unprotected departments’ – such as Justice, Environment, Food and Rural Affairs, Culture, Media and Sport, and Transport – would once again face the prospect of cuts. But remember these departments already face cuts of £8 billion in the second half of the parliament. Adding to those cuts is hard to square with the improvements to public services that Ministers have promised.

Figure 3: ‘Unprotected’ departments are already set for cuts of £8 billion by 2029-30

• Spending swaps – lower day-to-day spending, but more investment

The fiscal rule currently binding the Government relates to day-to-day spending (RDEL), rather than capital investment (CDEL), and this provides some wriggle room. Shifting some day-to-day spending to capital spending within departments would allow the Chancellor to meet the current balance fiscal rule without having to cut overall public spending.

However, such a change may not meet the needs of departments: building more prisons is no use if the Government cannot afford to pay enough wardens to staff them. Moreover, the Government still has its second fiscal rule, requiring ‘public sector net financial liabilities’ (PSNFL) to fall in the final year of the forecast, and this had only £16 billion of headroom in October. So even if the Government managed to meet its current balance rule by tweaking the mix of current and capital spending within total departmental budgets, it would still need to ensure it met its second fiscal rule, which is only slightly-less-binding.

Figure 4: The Government has a narrow margin of headroom against both its fiscal rules

• Rob the banks – reserves tiering

If the Chancellor doesn’t want to cut departmental spending (or raise taxes), then what other options are open to her? One option is to turn to the Bank of England. Currently, all the reserves deposited by commercial banks at the Bank of England earn interest, including lots of reserves created when the Bank bought gilts during quantitative easing. This makes the public sector’s debt interest costs particularly vulnerable to hikes in interest rates. Some have suggested that the Government should ask the Bank to move to move to a system of tiered reserves – like that already used by the European Central Bank. This would reduce the proportion of reserves that earn interest, saving the public purse significant sums of money. Recent analysis suggests this move could save the Government £4 to £5 billion by 2029-30, although the fiscal benefits of pursuing this policy would reduce significantly in future, as the Bank sells off the gilts it bought during quantitative easing.

But this option is not uncontroversial. It would amount to a significant reshaping of how the UK implements monetary policy, and it might be odd to undertake such a change just to create temporary fiscal space in reaction to movements in the bond market. On the other hand, if there are further upward pressures on Bank rate, then the cost of not making this change would grow – and it might also become easier for the Chancellor to u-turn on her previous position of not wanting to implement this change.

Stepping back, where does all this leave the Chancellor? Certainly not facing a full-blown fiscal emergency, but definitely a new year’s headache, albeit one made worse by her decision to set public finance plans that left her very low headroom.

But, now that she is faced with bond market jitters, the Chancellor should hold course before making major fiscal decisions that would have very real consequences for households. The Treasury is right to be concerned about the wider economic conditions we find ourselves in, and to plan for the Autumn Budget accordingly (with, ideally, moves to increase the headroom on both fiscal rules). But for now the best course is to keep calm and carry on.

[1] We have updated our projections for the growth in the RDEL spending envelope to start with the year 2025-26 to match the forecast period.