Economic Turmoil in the UK

The rate on the 10-year benchmark UK government bond has reached levels last seen in 2008. The rate on the 30-year bond stands at a 27-year high. Today, the Government sold £1 billion of bonds at the most expensive terms since 2004 – albeit with apparently good market demand. Sterling has suffered its worst trading losses for over two years. UK debt has risen to nearly 100% of GDP.  Inflation is proving to be sticky (recent OECD data showed the UK with the G7 highest inflation in November) – although today’s inflation figures show a small drop to 2.5%. 

Why is this happening?

International

It would be unfair to heap all the blame at the UK Government’s door.  Many of the factors fuelling the current market turbulence are outside the UK’s control.  The looming twin threats of President Trump’s tariffs and his tight immigration policy, together with rising oil prices (up nearly 10% in the first two weeks of 2025) have stoked global inflationary pressures, leading the world’s most powerful central banks to hold back on cutting interest rates and raising borrowing costs around the world. Markets appear to be pricing in higher US budget deficits and national debt (caused by Trump’s tax-cutting plans) adding to the supply of US Treasury bonds with resulting higher US interest rates and a stronger dollar.  All of which impacts the UK by pushing up  bond UK rates, increasing the deficit and hitting growth. 

Domestic

However, although bond rates are increasing across the globe (France, Spain and Germany have all seen similar increases), the UK does appear to be particularly vulnerable to this current bout of global economic uncertainty. A combination of uniquely-domestic factors (including the resilience of wage growth, service sector prices, and concerns about the inflationary impact of Labour’s tax and spend measures announced in the October Budget) has depressed consumer and business confidence and led to anaemic economic growth.

In October, the Office for Budget Responsibility (OBR) forecast that the chancellor’s main rule (to balance day-to-day spending, including debt repayments, with tax receipts by 2029-30) would be met with £9.9bn to spare. However, weaker than expected economic growth, stickier inflation, a higher Bank rate and higher long-term borrowing costs than expected in October mean that, by the time the OBR presents its March update, this headroom could be all but wiped out.

No one is (yet) making credible comparisons between current market instability and the turmoil that met Liz Truss’ mini-budget.  But the lesson from her tenure has been learnt: once the market’s confidence in the government’s ability to control the fiscal situation is lost, it is difficult to regain the sentiment.  That would explain why, despite protestations to the contrary, the Government last week looked a little rattled, deploying both Darren Jones and Rachel Reeves (twice) to try and calm the markets and yesterday the PM feeling it necessary to publicly offer his support to his Chancellor (normally a kiss-of-death for an embattled Minister…).

But the damage may already have been done.  A recent Bank of England survey showed that 61% of companies expected lower profit margins; 54% of UK firms were planning to raise prices; 53% to cut jobs; and 39% expected to pay lower wages than they otherwise would have done in response to the Chancellor’s increase in employers’ NICs.

Political Implications

One of the main promises Labour made during the election campaign was to bring an end to the cost-of-living-crisis. The current market turbulence means Labour is unlikely to deliver on this pledge in the short to medium term. Six months ago, the market had been forecasting the Bank of England would make up to four base-rate cuts in 2025.  Analysts now only expect two base-rate cuts this year, which would mean higher for longer borrowing costs, with implications for UK homeowners whose fixed-rate mortgage deals end this year. 

The other main promise that Labour made was to end austerity and invest in the UK’s over-stretched public services. However, that pledge runs into Reeves’ undertaking that October’s tax-raising Budget was a one-off and that there will be no more tax rises – which effectively closes off the possibility of filling the debt gap with new taxes in her March Statement. 

Since the Chancellor has also repeatedly promised that she will be iron-disciplined in meeting her own fiscal rules, if Government borrowing costs continue to rise, Labour will have no other choice but to cut spending in response.  The Treasury was already planning cuts to unprotected departments of more than 1% a year after 2026 (and rises of only 1.3% for others) – even though, after more than a decade of austerity, there may not be any fat left to cut in the public sector and trying to do so could be damaging for the economy. Economic conditions mean that Reeves could now be forced to announce deeper cuts before the end of March in order not to overshoot her fiscal rules when the OBR report is released. Making significant cuts to public services now would effectively also prejudge the outcome of the current zero-based Comprehensive Spending Review.

Politically, further cuts to the UK’s public services would be political kryptonite to Labour, seized on by their opponents and be catnip to Reform.  Though there is no question (yet) of a mutiny, a poll today showing Reform in second place, ahead of the Conservatives and only one point behind Labour has only exacerbated alarm among Labour MPs, whose confidence in Reeves is rumoured to be wavering. With yesterday’s resignation of Treasury Minister Tulip Sadiq being the second Ministerial resignation that Starmer has suffered in the first six months of his premiership, he can ill-afford any further slippage in support for Reeves, who is central to his plan for Government. 

The Government is therefore determined to wrestle back control of the agenda. Monday saw a significant announcement on the use of AI in the public sector. Later this week, Darren Jones, the Chief Secretary to the Treasury will give a speech on the Spending Review.  The Chancellor was in pugnacious form in the Commons yesterday and is targeting a major speech later this month on the government’s plan for growth (likely to focus on a rapid legislative timetable for deregulation and housebuilding) for her relaunch.  The government announced this morning that it will bring forward the delivery of the Industrial Strategy (several months before its originally-intended launch date) – an announcement which has been welcomed by the manufacturing sector.

So what could the Government could do?

The key date on which the Government is now focused is 26 March – when the OBR will publish its updated forecasts.  Those forecasts will make it clear whether rising gilt yields have already (or are likely to) see the UK breach its fiscal rules. Reeves’s Spring Forecast is on the same day.

Although Reeves has limited her room for manoeuvre by her own self-imposed triple lock – a commitment to her fiscal rules; no further increase taxes; and no return to austerity – there are things she could do in response to current market uncertainty:

  • Wait for the OBR’s report (the OBR will use market data nearer to 26 March for its report, leaving time for conditions to improve).  Waiting would also enable the Government to assess the market’s response to discovering whether Donald Trump’s Presidential inflationary tariff bite is better or worse than his campaigning bark;
  • Promise swingeing public sector spending cuts, but push them out to beyond the current spending review period, allowing a higher spend in the short term (and hope growth picks up in the interim); 
  • Set out plans for significant cuts to capital spending on new roads, railways, hospitals, schools etc (attractive in the short-term, but anathema to Labour’s plan to use higher investment to help kick-start long-term economic growth);
  • Although raising taxes would be unpopular with a business community already upset about October’s tax increases, the Government recognises that it cannot rebalance the economy on the back of public sector cuts alone and may be looking at options to introduce new taxes (for example a wealth-tax) or increase/unfreeze other taxes (for example CGT, alcohol/tobacco, APD, vehicle excise duty or the fuel escalator);
  • Hope for a Bank of England rescue. The fall in inflation announced this morning – though small – does open a narrow path for the BoE to lower interest rates: the next meeting of the Bank’s rate-setting committee is on 6 February, with government debt and a weaker Pound currently pulling the interest rate decision in opposite directions.

Comment

The Government is in a difficult position.  It needs long-term economic growth to fund much-needed investment in the public sector.  It needs short-term funding to make a difference to voters’ pockets now.  It changed long-established fiscal rules to allow borrowing for infrastructure investment. But borrowing costs have gone up and the government needs to find a way to meet those costs – so an invidious choice awaits: tax rises or spending costs?  

The PM’s response to the CBI earlier this week made it clear that the Government will not take the chance of further irritating the business community by seeking more tax rises. By contrast, when asked about the implications of global economic uncertainty for the Spending Review, the PM replied ‘we will be ruthless’.  That response leads to the conclusion that the Government will plot its path out of this maze-of-its-own-making by relying on the ambiguity of the word ‘austerity’ and arguing that making efficiency savings in the public sector through civil service reform does not constitute actual ‘austerity’ – especially if those changes are back-loaded to the end of the Parliament when (hopefully) the economy will be in better health.    The Government’s big AI Announcement supports the logic of this approach. Labour recognises that it will take time for AI to have an effect, but is betting that by, the end of this Parliament, AI (and the attendant infrastructure investment) will compensate for public sector cuts by reducing public sector expenditure, whilst at the same time delivering improvements in public sector delivery and efficiency and injecting growth into the economy.  This is a risky play, not least as it increases the likelihood of conflict with both the Unions (over public sector job losses) and the general public (over public sector cuts). But Labour has hemmed itself in and increasingly has nowhere left to turn.

Photo of Thomas Reilly Thomas Reilly

Ambassador Thomas Reilly, Covington’s Head of UK Public Policy and a key member of the firm’s Global Problem Solving Group, draws on over 20 years of diplomatic and commercial roles to advise clients on their strategic business objectives.

Ambassador Reilly was most recently…

Ambassador Thomas Reilly, Covington’s Head of UK Public Policy and a key member of the firm’s Global Problem Solving Group, draws on over 20 years of diplomatic and commercial roles to advise clients on their strategic business objectives.

Ambassador Reilly was most recently British Ambassador to Morocco between 2017 and 2020, and prior to this, the Senior Advisor on International Government Relations & Regulatory Affairs and Head of Government Relations at Royal Dutch Shell between 2012 and 2017. His former roles with the Foreign and Commonwealth Office included British Ambassador Morocco & Mauritania (2017-2018), Deputy Head of Mission at the British Embassy in Egypt (2010-2012), Deputy Head of the Climate Change & Energy Department (2007-2009), and Deputy Head of the Counter Terrorism Department (2005-2007). He has lived or worked in a number of countries including Jordan, Kuwait, Yemen, Libya, Iraq, Saudi Arabia, Bahrain, and Argentina.

At Covington, Ambassador Reilly works closely with our global team of lawyers and investigators as well as over 100 former diplomats and senior government officials, with significant depth of experience in dealing with the types of complex problems that involve both legal and governmental institutions.

Ambassador Reilly started his career as a solicitor specialising in EU and commercial law but no longer practices as a solicitor.