Rachel Reeves intended to spend January burnishing her reputation on the global stage with trips to Beijing and Davos, and flipping the focus from her £40bn tax-raising budget to Labour’s plans to rekindle economic growth.
Instead, the chancellor was reduced to watching anxiously, as a sell-off swept through government bond markets, and sterling came under intense pressure as a result.
There was little new data on this side of the Atlantic to justify the market moves. US bond yields have been drifting upwards, as investors guess that inflation will remain higher for longer than previously thought.
Part of the step up in borrowing costs in the UK, after yields – in effect the interest rates – on 30-year government bonds, or gilts, hit their highest level since May 1998, echoed the US. But there also appeared to be UK-specific concerns at work.
Recent economic data has suggested gross domestic product is flatlining, while wage growth is accelerating; and a string of retailers have warned that Reeves’s increase to employers’ national insurance contributions (NICs) will force them to push up prices.
That has left some investors fretting that the UK is headed for “stagflation” – a nasty combination of weak economic growth and persistently high inflation that is a headache for policymakers.
Despite growth being near zero, and signs that the jobs market is deteriorating, Bank of England policymakers appear reluctant to press ahead with cutting interest rates from 4.75% because of fears that inflation will prove sticky.
Sarah Breeden, one of the Bank’s deputy governors, argued this week that in the current circumstances, it was, “difficult to know how quickly to remove the restrictive policy”. One rate cut is widely expected in February, but the path beyond that is unclear.
Against this gloomy economic backdrop, markets also appeared to be fretting about the sustainability of Reeves’s tax and spending plans – despite the £40bn-worth of tax increases she announced at the budget.
As these concerns drove up gilt yields throughout the week, Neil Shearing, the group chief economist at Capital Economics, raised the spectre of the nightmare scenario in which the bond market sell-off became self-reinforcing.
“Where we’re getting to – and this is where it becomes dangerous for the government – is that this almost becomes a slightly self-fulfilling prophecy. You get a sell-off in the bond market, which pushes up government borrowing costs, which exacerbates concerns about the fiscal position, which refuels the sell-off in the bond market, and the whole thing feeds on itself,” he said.
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Other things being equal, analysts said the jump in bond yields appeared to be enough to wipe out the £9.9bn “headroom” Reeves had left herself.
As the rollercoaster week went on, the Treasury sought to staunch any fears of fiscal backsliding, by hinting heavily that the chancellor was prepared to squeeze future spending plans at her March statement, if higher bond yields put her on course to bust her fiscal rules. Those rules were, the chief secretary to the Treasury, Darren Jones, told MPs on Thursday, “non-negotiable”.
Paul Johnson, the director of the Institute for Fiscal Studies thinktank, pointed out that if Reeves did opt to make emergency cuts to her already tight spending plans, it would underline the absurdity of the way the rules function.
“As with all these fiscal rules, if you set yourself a rule and give yourself no headroom against it, and you promise you’re always going to meet this rule, then you end up in this absurd position of having to fine tune at every fiscal event,” he said.
For campaigners who have been urging Labour to do more to tackle child poverty, or restore aid spending to 0.7% of national income – not to mention Labour-supporting trades unions hoping for a decent pay rise – the prospect of a fresh spending squeeze is alarming.
Much will depend on how the economy evolves in the coming weeks and months: business groups have complained vigorously about the NICs rise, but as yet it is unclear what the impact on either growth or inflation will be.
Reeves is planning a speech at the end of January, setting out her stall on economic growth.
Away from the market noise, government insiders insist there are reasons to be optimistic. They point to the links between the additional funding the chancellor is providing for the NHS and local councils, and future growth – as well as longer-term changes aimed at increasing housebuilding and helping people back into jobs.
“People are underestimating how pro-growth the budget was,” said one Labour source, adding: “Who really thinks there’s an alternative to sorting out public services?”
Meanwhile, some analysts believe it is the “‘flation” part of the stagflation scare that is overblown, with inflation expected to tumble, opening the way for lower interest rates. HSBC is in this camp. Its chief European economist, Simon Wells, is pencilling in six rate cuts from the Bank in 2025.
The latest inflation data, which is to be published next Wednesday, may provide some additional clarity.
Whatever the outlook over the year ahead, however, Reeves looks likely to return from China to another anxious week of second-guessing the City. And many past chancellors have learned to their cost the mighty power of the markets.