The UK economy faces an increasingly precarious fiscal future as Chancellor Rachel Reeves struggles with diminishing financial flexibility.
The National Institute of Economic and Social Research (NIESR) has warned that by the time new economic forecasts are released next month, Reeves will have exhausted nearly £10 billion in headroom against her self-imposed budget stability rule. This situation raises the likelihood of further tax increases or spending cuts, exacerbating economic uncertainty.
Reeves has committed to ensuring that day-to-day government expenses are funded by income, rather than borrowing, by the end of this parliamentary term. While the NIESR suggests that she will narrowly meet this goal, it also highlights a concerning lack of fiscal room to address any future economic shocks.
The government’s fiscal position has been severely impacted by a sharp sell-off in UK government bonds earlier this year, alongside market expectations that the Bank of England will not significantly lower interest rates in 2025. These factors have eroded the chancellor’s already limited budgetary maneuverability, making it difficult to respond to unexpected financial downturns or invest in long-term growth initiatives.
Limited Options for Economic Stimulus
According to the NIESR, Reeves’s adherence to Labour’s fiscal constraints on taxation leaves no room for additional government expenditure. This means that any unforeseen economic difficulties over the next few years will have to be managed without additional spending measures. The institute’s quarterly economic outlook underscores the risk that the UK economy may be unable to withstand external shocks without further tightening of fiscal policy.
The Office for Budget Responsibility (OBR) is currently revising its economic forecasts, incorporating new data on government policy and economic trends. Its revised estimates, set for publication on March 26, will determine the government’s remaining fiscal headroom under Labour’s target of balancing day-to-day spending by 2029-30. Given the worsening fiscal landscape, the OBR’s findings could force Reeves to consider alternative revenue sources or additional spending cuts to maintain financial stability.
Tax Rises or Further Austerity?
Despite the pressures, Reeves has ruled out announcing further tax increases in the spring. However, she may have no choice but to introduce new fiscal consolidation measures in the autumn budget. Without additional tax revenue or spending reductions, the government risks breaching its fiscal targets, potentially undermining investor confidence and economic growth.
The economic climate is further complicated by interest rate expectations. The Bank of England is projected to cut rates only twice more—once in 2025 and again in 2026—bringing the base rate down to 4% by the end of next year. Meanwhile, inflation is expected to rise to 3.2% in early 2025 before declining to 2.4% by the end of the year and ultimately stabilising at the Bank’s 2% target.
While these projections suggest gradual economic stabilisation, they offer little immediate relief to the government’s fiscal challenges.
External Economic Threats
Global economic developments are also poised to impact the UK economy. The re-election of Donald Trump as U.S. president and his proposed tariff policies could further strain UK growth.
The NIESR previously calculated that a 60% tariff on all Chinese goods, combined with a 10% tariff on imports from the rest of the world, would reduce UK GDP by 0.2 percentage points in the first year while pushing consumer price inflation up by 0.4 percentage points. Such trade disruptions would add to the government’s economic woes, limiting growth prospects and increasing cost pressures on consumers.
A Precarious Economic Future
With zero fiscal headroom remaining, the UK government faces a period of financial rigidity that leaves it vulnerable to economic shocks. The NIESR’s warning underscores the risks associated with Reeves’s current fiscal approach, particularly given the likelihood of further economic turbulence in the coming years. Without adjustments to taxation and spending policies, the government has no financial buffer to mitigate potential downturns, making it imperative for policymakers to explore alternative strategies for economic resilience.
As the OBR prepares to release its updated forecasts, the UK government’s fiscal position will come under intense scrutiny. If the economic outlook continues to deteriorate, Reeves may be forced to reassess Labour’s budgetary constraints or implement difficult fiscal measures to maintain economic stability. In the meantime, the UK remains in a precarious financial position, with limited options to stimulate growth or protect against external shocks.
Main Image: By The wub – Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=125332702
