The OBR calculation that could reshape the next Budget

The surge in government bond yields could hardly have come at a worse time for the government, as the OBR starts to calculate the impact of higher debt interest costs and inflation. This will make an already difficult fiscal arithmetic problem even harder. The almost certain outcome is higher taxes and borrowing. But the crucial test will be whether markets accept promises of future fiscal consolidation. If not, borrowing costs will rise further.

Guilty as charged - UK borrowing costs rise again

Although the latest sell-off in bond markets has been a global phenomenon, as we covered in our previous The Week Ahead, gilts are once again at the forefront. This means the UK government’s borrowing costs have risen by more than those of most other governments. A combination of factors is at work: the UK is more exposed to inflation and has more inflation-linked debt than other countries. But UK debt also clearly carries a sizeable risk premium, driven partly by perceptions of the additional government spending that may be coming over the next few years. So Burnham does not get off scot-free.

Of course, any surge in bond yields is unwelcome news for the government — ask Liz Truss — but this one has come at a particularly inconvenient time. The OBR is likely to begin assessing the effect of gilt yields on the government’s finances ahead of the next Budget. It does this by taking a snapshot of market expectations for interest rates and gilt yields over a ten-day period in the run-up to the Budget. We do not know exactly when that period will begin, but based on previous timetables it is likely to cover the ten working days to 23 September, meaning the window may open this week.

Higher debt interest costs reduce the Chancellor’s fiscal headroom

Based on the latest interest-rate and gilt-yield data, the government’s headroom against its fiscal rules has probably shrunk by about £9bn. The last Budget increased that headroom to £23.6bn, so the chancellor would still have £14.6bn left. However, higher inflation and lower migration forecasts will also take a chunk out of it. There is considerable uncertainty, but our best estimate is that these factors will cost a little over £3bn, leaving headroom of roughly £11.5bn.

That would still be more than the £9.9bn Rachel Reeves left herself after her first Budget. The chancellor could reasonably argue that this is precisely the kind of geopolitically driven hit that the headroom is intended to absorb. We therefore do not think he will necessarily have to raise taxes to offset the effect of higher interest rates. Indeed, the Treasury can probably live with headroom above £10bn.

However, that does leave him in a precarious position. The reason that Rachel Reeves decided to more than double the headroom was because such a narrow buffer created endless speculation about what taxes would have to go up every time there was a change in gilt yields. That speculation was bad for growth.

Why the UK’s fiscal buffer remains precarious

What is more, the argument that this is a temporary shock looks shaky. The Iran–US conflict driving up inflation shows no sign of ending soon. Even if it does, much of the increase in gilt yields is being driven by structural forces related to the vast issuance of government and private debt, as we covered last week. That is unlikely to change this decade, meaning gilt yields are likely to remain high even if there is a lasting peace deal involving Iran.

That combination would support taking action to restore at least some of the lost headroom. It would also reassure markets of his commitment to fiscal discipline.

In any case, the lack of headroom means that any additional spending will have to be financed through higher taxes or borrowing. Many ambitious spending plans have been floated since Burnham took office, but the two most pressing are increasing defence spending to 3% of GDP, at a cost of around £10bn, and taking action to reduce the cost of living. Funding these priorities will almost certainly require further tax rises, more borrowing or, most likely, a combination of both.

That is difficult to do within the constraints of the current fiscal rules and while sticking to the manifesto pledges not to raise income tax, VAT or national insurance. Embarking on a fresh borrowing binge at a time when inflation is rising and the bond market is twitchy would be a very risky strategy.

That raises the prospect that the new administration’s first Budget will be something of a damp squib, focused on temporary measures to ease the cost of living while most major spending plans are pushed into the next parliament.

We will write more as the Budget plans become clearer, but for now the direction of travel is clear: more taxes, more spending and more borrowing. Get it wrong, and we will all pay through higher mortgages as well as higher taxes.

Despite elevated energy prices weighing on real income growth and persistent uncertainty, the latest credit data suggest that consumers — at least so far — remain willing to spend.

Consumer credit rose from £1.9bn to £2.0bn in July, its highest level since November. Alongside annual growth in new car registrations accelerating from 11.7% to 13.7% in August, this suggests consumers remain willing to use credit to finance major purchases — a positive sign for growth.

Indeed, the latest update to our credit impulse shows that consumers are taking on more credit than they were at this point last year. Combined with consumer confidence reaching a two-year high, this suggests that households are willing to keep consumption growth ticking along through a mixture of increased borrowing and slightly lower saving.

The main heading rag on activity probably came from mining, where we expect output to fall by 5.0% as June’s surge unwinds, based on the signal from North Sea loadings. That said, we expect manufacturing to offset this decline, with output rising by 0.6% as demand appears to be supported by more than a temporary boost from efforts to get ahead of supply shortages.

Elsewhere, we expect services output to be mixed. Hospitality output is likely to have risen strongly in July, boosted by England’s World Cup performance. However, retail sales fell by 0.5% on the month, suggesting consumers shifted spending towards hospitality rather than increasing their overall expenditure.

Turning to business services, we think the usual stalwarts of IT, professional services and administration continued to expand in July, based on the signal from the improving Services PMI. Admittedly, our forecast is below the survey’s indication because activity in these sectors far exceeded expectations in June, making some payback likely. Looking at the bigger picture, strong business sentiment — despite renewed tensions in Iran and the prospect of another tax-raising budget — should allow services activity to continue driving growth in the second half of the year, albeit at a subdued pace.

Ultimately, the UK economy probably did little more than stagnate in July as the one-off factors that boosted growth in June unwound. Further ahead, firms will have to contend with softer demand. We expect growth to slow to around 0.2% per quarter in the second half of the year, compared with 0.5% in the first half, as higher inflation weighs on real household incomes and higher market rates constrain investment.

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