Financial markets have responded calmly to the Government's new Budget, but that apparent acceptance masks a harsh reality: the figures do not add up without major tax increases and deep cuts to public spending, according to analysis by leading economists. The Institute for Fiscal Studies described next year's spending review as brutal and warned of the worst decade for growth in household incomes on record.
The core problem lies with borrowing. The Office for Budget Responsibility forecast in spring that the deficit for this financial year would equal 3.6 per cent of GDP, but it now expects 4.2 per cent. Equivalent rises in the deficit are projected through to 2030-31. This trajectory is unsustainable. The UK already pays more to borrow than any other major economy, suggesting markets have concerns about the Government's ability to manage its finances. Economists say the Government faces a choice: either it takes tough action on its own, or rising bond yields will force action upon it.
Interest rates will rise sharply alongside any spending cuts. The Bank of England's base rate is expected to increase to 4 per cent this week, the first rise in more than three years, after holding at 3.75 per cent since December. Long-term bond markets have already pushed 30-year borrowing costs to 5.7 per cent. City economists expect one or two further rate rises next year, though markets are pricing in three or four. A Bank rate of 5 per cent by early 2028 is possible. The Bank of England is the last major central bank to start raising rates, following moves by the US Federal Reserve, the European Central Bank, and the Banks of Japan and Canada.
Higher interest rates will dampen demand and inflation, though the transmission mechanisms work differently than in the past. A rise to 4.75 per cent by next autumn could cut overall demand by between 0.5 and 1 per cent, though the full effect takes a year to materialise. Inflation could fall by up to half a percentage point, but only over two years. The housing market, normally a major channel through which rate changes affect the economy, now transmits less force because most mortgages are fixed-rate, leaving borrowers unaffected until their deals expire.
The economic squeeze will hit businesses and households hard. During previous periods of tax rises under the previous Chancellor, the Bank of England was cutting rates, which provided some offset to the economy. That dynamic will not exist now. Firms will face simultaneous pressure from higher taxes and higher borrowing costs. For households, the combination of higher taxes and elevated interest rates will persist for an extended period.
For savers, borrowers and businesses in the UK, this means higher mortgage costs, more expensive business loans, reduced household incomes and a prolonged period of economic constraint as the Government grapples with its fiscal position.