Key Takeaways
- Lacklustre growth together with looming higher spending on defence mean that the UK government’s fiscal headroom is under pressure. What are the Chancellor’s options?
- The International Monetary Fund has delivered a mixed message to Chancellor Rachel Reeves. They reinforced the importance of adhering to fiscal rules while also recommending more flexibility to avoid frequent policy adjustments.
- Bond markets are pushing the UK (and other developed economies) to borrow shorter-dated debt to mitigate rising long-term interest rates. This could ease some pressures at the margin.
- Despite commitments to avoid additional borrowing or taxes, speculation persists that the Chancellor will need to take such measures to maintain fiscal discipline.
- With a view to balancing political and market considerations, amending fiscal rules to incorporate more flexibility may prove to be the best path forward.
The UK’s public finances are once again in focus with the departmental spending review taking place this week. Recent weeks have seen the government change course on welfare policies, the costs of which will erode the fiscal headroom which has been the subject of so much anxiety in the Treasury since the last election. In addition, further spending commitments around defence and cuts to growth forecasts means the Chancellor once again will likely need to make spending cuts or raise taxes to avoid breaking her fiscal rules.
The International Monetary Fund (IMF) recently delivered a mixed message for the Chancellor Rachel Reeves, urging her to stick to her fiscal rules and keep spending under control but also suggesting there needs to be more flexibility in the rules to avoid constant policy adjustments. The IMF suggested “further refinement” of the fiscal rules to avoid small economic revisions in the OBR’s semi-annual forecast updates wiping the government’s fiscal headroom and creating pressure for frequent policy changes.
The IMF suggested moving to one OBR forecast a year and, changing how forecasts are communicated to reduce the emphasis on specific headroom figures and a formal process to avoid small breaches to the fiscal rules from triggering corrective action.
In better news the IMF increased their 2025 growth forecast to 1.2% from 1.1%. In worse news, this compares to a pre-tariffs forecast of 1.6%. Medium term growth was forecast to be “subdued” at around 1.4% owing to continued “weak productivity”.
The IMF upgrade included a warning for the Chancellor that her fiscal ‘room for manoeuvre’ was inadequate, making further spending cuts or tax rises necessary “if shocks arise”. In addition, the IMF said deficit reduction was still necessary “to stabilise net debt and reduce vulnerability to market pressures”.
Bond markets appear to be forcing the hand of the UK and other developed market countries such as Japan and the US to borrow shorter dated debt to avoid higher interest rates at the long end of the curve. Rising rates alone eradicated Rachel Reeve’s ‘wiggle room’ between last October and the Spring Budget, so if the Debt Management Office can issue cheaper, shorter dated debt then this could ease some pressures at the margin.
Will the Chancellor change her position? Last autumn, after the Budget that saw £40bn of extra taxes announced, Rachel Reeves told a CBI conference “I’m really clear, I’m not coming back with more borrowing or more taxes”. But there is still plenty of speculation the Chancellor will need to increase taxes, or borrowing, or both, to stay in the narrow fiscal boundaries she has set herself, having doubled down by describing them as “non-negotiable” and “iron clad”. The challenges continue to mount – the government will reverse the controversial cuts to the winter fuel payments, and defence spending is on a higher trajectory over multiple years. Risks of continued mediocre growth and downward revisions to productivity forecasts from the OBR that still appear far too optimistic are further concerns.
The IMF has noted that no other country is so obsessed with small movements in the public finances and believes the focus on fiscal headroom is leading to poor decision making. Could the government test the waters of financial markets and borrow more? The Liz Truss era still weighs heavily on the government’s thinking and its determination to look credible on public finances.
The Autumn Budget is still some time away, and the government will hope the stronger than expected economic performance in Q1 is sustained. Self-imposed rules suggest no increases to the big four taxes – income, VAT, corporation and national insurance. Prime Minister Keir Starmer spoke last week of his opposition to “taxing your way to growth”. The obvious path therefore is amending the fiscal rules to build in more flexibility. The Chancellor can point to the IMF’s supportive comments but will be anxious not to trigger a negative market response. If the OBR forecasts and higher interest costs once again wipe out the fiscal headroom, the Chancellor will walk a very fine line between upsetting her political party or the financial markets.
