Analysts are warning that a sharp slowdown in economic growth and rising borrowing costs could strain the government’s finances, forcing Chancellor Rachel Reeves to reconsider her pledge not to raise taxes further.
Heading into the Christmas season, the UK economy faces a grim outlook. Inflation is climbing again, the London stock market has slumped to its lowest level in over a month, and the Bank of England has forecast stagnation for the final quarter of 2024. Adding to the uncertainty is the looming threat of a trade war with the United States.
President-elect Donald Trump, set to take office in January, recently issued a warning via social media, threatening tariffs on EU exports to the US, with a possibility of extending those to the UK. Markets have already responded negatively to the prospect of deteriorating trade relations.
City economists say that the recent inflation surge will likely compel the Bank of England to maintain elevated interest rates, which would dampen household spending and hinder Reeves’s plans for economic expansion.
Inflation rose to 2.6% in November, up from 1.7% in September, while wage growth climbed to 5.2%, according to official statistics. Bank officials, citing persistent inflationary pressures, kept the base rate at 4.75% last week.
Companies have blamed the chancellor’s autumn budget for diminishing consumer confidence and weakening demand for new hires.
The EY Item Club predicts that over half of Reeves’s fiscal flexibility during this parliament could evaporate if high interest rates persist into 2025. Financial markets, which had anticipated multiple rate cuts next year, now expect only two quarter-point reductions, leaving rates at 4.25%.
Higher borrowing costs have also pushed long-term UK government debt yields to levels not seen since the fallout from the 2022 mini-budget. On Thursday, 30-year bond yields neared a 26-year high of 5.15%, and 10-year gilts reached their highest rate in over a year at 4.65%.
The London stock market has reflected these mounting concerns. The FTSE 100 dropped 1% on Friday to its lowest level in five weeks and recorded its largest weekly decline since October 2023. Once at a record high of 8,474 points in May, the index has shed 3% of its value in December alone.
Fiscal Constraints Threaten Spending Plans
The Treasury’s independent forecaster, the Office for Budget Responsibility (OBR), estimates that government borrowing will reach nearly £130 billion this financial year.
This would leave Reeves with approximately £10 billion in fiscal headroom to meet her goal of reducing the annual deficit to near zero by 2030.
Despite November borrowing figures of £11.2 billion — the lowest for that month in three years — analysts caution that this does not signify a long-term improvement.
Matt Swannell, chief economic adviser at the EY Item Club, noted, “Figures showed the health of the public finances in November were better than expected, but still left the government on course to lose more than half the headroom to maintain its public spending plans.”
He added that navigating next summer’s review of Whitehall spending will be a formidable task without additional revenue from higher taxes.
Meanwhile, Rob Wood, chief UK economist at Pantheon Macroeconomics, projected that inflation could rise further to 3.1%, forcing the Bank of England to maintain high interest rates for an extended period.
A significant portion of the UK’s debt is held in index-linked bonds, which track the retail prices index (RPI). These, combined with high central bank interest rates, could upend the OBR’s calculations that borrowing costs will decline over the next five years. Without reductions in these costs, Reeves may struggle to allocate funds for welfare and public services.
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