Is Britain’s future burning as bright as Rachel Reeves says it is?

As the chancellor prepares to plug the country’s prospects to world leaders in Davos, Sean O’Grady asks if she has a real chance of beating inflation or if her plans are set to go down in flames

Preparing for her appearance at the World Economic Forum in Davos in a couple of weeks, the chancellor declares herself confident that Britain’s economic future is “burning bright”: “I am on a mission to win round the world’s investors.”

Fair enough, but even Rachel Reeves herself might concede that 2025 is going to be another tough year for the public finances, and that investor confidence is proving a little bit brittle. The interest rates demanded by lenders to the government have been edging up recently, and have been setting unwelcome records.

Economists warn that Reeves is in danger of breaking her own “iron-clad” fiscal rules. To avert that, she may need to raise taxes again, cut public spending, or both. The “tough choices” that the government said would have to be taken after the general election are far from over...

How bad is it?

Well, the rates on very-long-dated government bonds – the principal repayable in 30 years – are at their highest since 1998, now sitting at around 5.35 per cent. These are largely used by pension funds to manage their future liabilities, and are a significant part of the market. More relevant for the home loan market is the 10-year gilt rate. This is now at its highest since October 2008, about to reach 4.8 per cent.

So it’s good news for savers and those looking to purchase a pension annuity, but bad for homebuyers and the property market. Even before the most recent moves, the Office for Budget Responsibility was forecasting that the best mortgage rates would go up from 3.7 per cent to 4.5 per cent in 2027.

For the public finances, it means that instead of having about £10bn of “headroom” to meet her borrowing and debt objectives in the coming years, Reeves is now looking at a wafer-thin margin of £1bn – set against annual borrowing of about £71bn projected for 2029-30, and £128bn for this financial year.

Why is it happening now?

Because of inflation. Though it has collapsed from its recent annual peak in October 2022 of more than 11.1 per cent, the “last yards” in getting it down to around the 2 per cent official target are proving much more difficult. This is because of global trends and still elevated energy costs, and, in the UK, labour and skills shortages pushing wages up, exacerbated by Brexit and a more hostile public attitude to migration.

The increase in employers’ national insurance contributions and the hike in the minimum wage are also to some extent being passed through in higher prices and charges. When inflation appears to be higher than expected, investors need an additional return for taking on the risk.

So does disaster beckon?

No, but Reeves will need considerable luck to avoid having to squeeze public services and taxpayers still further. On the upside, if growth is higher than expected – because, for example, the planning reforms unleash lots of investment, or if world energy prices decline after the (prospective) end of the Ukraine war and Trump’s plan to expand drilling – then inflationary pressures will ease.

And the downside?

Grim. One of the main “known unknowns” is just how seriously we should take Trump’s warnings about raising tariffs and launching trade wars with China, the European Union and others. Tariffs are inflationary, depress growth, lower living standards, and make running an economy that much harder. Given the UK’s healthy export trade with the US, Trump’s tariffs on cars, Scotch and the rest could push Britain’s feeble growth prospects down to zero.

Is it worse than the Truss experiment?

Obviously not. There is not the same sense of crisis, the UK is still in line with the global “pack” of advanced economies, the pensions market is calm, and the pound hasn’t collapsed to a 40-year low against the dollar inside 48 hours. It’s bad, but not that bad.

What are the politics of this?

In the short to medium term, Reeves may be faced with the humiliation of having to introduce – dread term – a “mini-Budget” of measures to bring the public finances back on track. In the longer term, failure to deliver modest growth in living standards and improvements in public services will cost Labour dear at the next election; inflation kills popularity, as do high mortgage rates. The Tories’ record and lack of a convincing alternative will hold them back, but Reform is free to promise the earth.

The irony may be that, like Biden in America giving way to Trump, Labour will do all the hard, deeply unpopular work to make the UK public finances sustainable and raise investment, but will miss the subsequent opportunity to enjoy the rewards.