Tax Hike Fears Mount as Chancellor's Fiscal Headroom Shrinks

Strategic Insights -

Rising borrowing costs are poised to eradicate around half of Chancellor Rachel Reeves' £9.9bn headroom, a leading economics consultancy has warned. Despite making £14bn in spending cuts in the Spring Statement two months ago, Reeves has left herself with one of the slimmest fiscal buffers on record. Fresh calculations suggest Reeves may have to make more radical cuts in the coming months to stick to her strict fiscal rules, which require the public budget to be in balance or surplus on a three-year rolling target.

Key Takeaways:

  • Oxford Economics' Andrew Goodwin estimates that around £4.5bn of the headroom pencilled in the final year of the Office for Budget Responsibility (OBR)'s forecast will be eradicated if gilt yields stay at their current level and two more interest rate cuts are made this year.
  • Gilt yields are 20 to 25 basis points higher than they were for the spring statement forecasts, and market expectations for Bank Rate are "a little higher", Goodwin warned.
  • The Chancellor may 'need to increase' taxes or cut spending if the UK government cannot reduce its national debt and maintain its fiscal headroom.
  • The latest episode saw credit ratings leader Moody's downgrading the US one level from a triple-A rating, citing surging government debt levels and a deeper budget deficit.
  • JP Morgan chief executive Jamie Dimon accused investors of becoming "complacent" after the S&P 500 barely moved after the downgrade was revealed.
  • Investors are worried about the level of gilts being issued as well as the high level of interest rates set by the Bank of England.
  • The spending review, due in the summer, will be the next indicator of whether the Chancellor is serious about lowering the national debt and keeping her small headroom intact.
  • Should cuts not be made, tax rises would be more likely, according to Ben Nicholl, a senior fund manager at Royal London Asset Management.

Statistics:

  • £9.9bn: Chancellor Rachel Reeves' small headroom
  • £14bn: Spending cuts made by Reeves in the Spring Statement two months ago
  • £4.5bn: Headroom estimated to be eradicated if gilt yields stay at their current level and two more interest rate cuts are made this year
  • 20-25 basis points: Higher gilt yields compared to the spring statement forecasts
  • 5.5%: Peak level of UK 30-year yields before falling back
  • £300bn: Gilt issuance this year, plus what is expected over the next few years, a high level for the bond markets to take on

Sources:

  • [City AM: Reeves doubles down on fiscal rules amidst waning headroom]
  • [City AM: Mervyn King hits out at Reeves' flawed fiscal rules]
  • [City AM: Reeves must provide more stable tax policy, finance bosses say]
  • [The Guardian: US credit rating downgrade could add to pressure on government debt]
  • [City AM: Interest rate cuts need to slow down to curb inflation, says Huw Pill]
  • [City AM: Reeves needs to make long-overdue changes to spending, CBI says]
  • [City AM: RBC BlueBay Asset Management portfolio manager Neil Mehta]