This ‘iron chancellor’ is at the mercy of external events
By Simon French, Chief Economist and Head of Research
Last week saw two important milestones for the UK public finances. The first was an updated Bank of England forecast downgrading the UK growth outlook. The second was the latest assessment from the Office for Budget Responsibility (OBR) on the government’s progress against its self-imposed fiscal rules. Whilst the Bank of England’s workings were made public enabling a post-mortem of its decision to cut interest rates, the OBR’s document was, as convention dictates, a private missive to Chancellor Rachel Reeves. In doing so, the OBR provided Reeves with her first official guide as to whether she needs to stick, or twist, following her October Budget. Speculation is rife that the Chancellor will need to twist. A range of external economic forecasters have suggested that higher borrowing costs on global markets, the slowdown in consumer and business sentiment, and higher energy costs will combine to eliminate the modest headroom Chancellor Reeves left herself in the Autumn.
It is now gin clear that economic growth has flatlined since last July’s General Election. A further update from the Office for National Statistics on Thursday risks showing a contraction of output in the last quarter of 2024. Confidence surveys for the first half of 2025 are signposting little better. Overburdening employers through a simultaneous 6.7% increase in the National Living Wage, a £24.5bn increase to Employer National Insurance Contributions, and an Employment Rights Bill with an upfront cost of almost £5bn appear to be the principal concern. However it should be noted that it was the 20% spike in gas prices over the winter that did most of the damage to the Bank of England’s latest growth forecast. The UK economy clearly remains too geared to volatile gas prices. This provides both the justification to go further and faster on renewables and nuclear energy alternatives - but also brutally exposes the truth that the licencing and taxation approach to North Sea oil and gas developments are inconsistent with Reeves’ vision for Securonomics.
The international economic backdrop has also darkened. Inflation expectations have spiked in the US economy amidst fears of higher import tariffs, and unfunded tax cuts. The University of Michigan’s closely-watched inflation expectations survey jumped to 4.3% in February – its highest level in over a year. Fears in financial markets that isolationist US economic policies will have long-lasting impacts on consumer prices has pushed up the cost of borrowing for the US government. In turn this has dragged up the UK equivalent – Gilt interest rates – towards multidecade highs. Whilst the most acute pressure in this market has eased since mid-January the OBR looks on track to assume materially higher borrowing costs for the Treasury than it did back in October.
So far, so downbeat. But it would be remiss not to mention other factors that could play to the Chancellor’s advantage. There has been a noticeable pivot towards a more pro-growth narrative since the turn of the year. Previously ideological no-goes on South-East airport expansion and nuclear power have been broached. If this suggests a pragmatism in the face of evidence and events that should be a feather in the Chancellor’s cap. Whilst neither policies will have a material impact on UK growth anytime soon - and forgive us all for cynicism that we have heard this all before from previous UK governments - the pivot has been noticed by the business community who wonder out loud why this more upbeat tone was ‘missing in action’ in the months after the General Election. If this gear change is a sign of renewed political backbone to take on vested interests on planning reform, the role of judicial reviews, pension reform, and amongst the UK’s myriad of regulatory bodies then the medium term growth outlook need not be so dire. And whilst a number of external forecasters have guessed that that Chancellor’s £9.9bn of headroom against her ‘current budget’ rule has all gone - there are now new population estimates available which will introduce more flux into the OBR’s thinking surrounding the UK finances.
The reality is that only a handful of personnel within the Treasury know for sure how things are shaping up – but it is obvious from the mood music that things are precarious. There has been a tougher tone surrounding the 5% efficiency savings expected of departments during the ongoing Spending Review, and in the area of welfare reform. Whilst it is easy soundbite for opponents to suggest a paring back capital projects like High Speed Two this would contribute next to nothing to getting current spending back into balance – the most binding of the Chancellor’s fiscal rules. More realistic are definitional tweaks to the “iron-clad” fiscal rules and a paring back the voluntary losses that the Bank of England is making from its ongoing sale of Gilts. Let no stone be left unturned.
There are those who look on at such a circus and rightly question why the world’s sixth largest economy ties itself in political and economic knots in this way. September 2022 - and the fallout from the Mini Budget - was a totemic example of why such guardrails are important. When the UK state - on behalf of all of us - continues to run two large deficits on trade and its public finances then it is beholden to display virtue. The creditors to the UK public sector - both at home and abroad - have plenty of choices should they choose to lend their money elsewhere.
No, the problem here is the government leaving itself such little headroom - less than 1% of public spending. One percent is just a third of the average amount of fiscal space left by Budgets since 2010. If Reeves is forced into remedial actions on the 26th March the original sin was the naivety to leave such little headroom. None of us know how external events will unfold, particularly not with Donald Trump in the White House. Leaving the stability of the UK public finances at the mercy of relatively small changes in economic conditions is not what Iron Chancellors do.
