Labour 'could be forced to hike taxes or cut spending' as cost of government borrowing soars

9 January 2025, 08:10 | Updated: 9 January 2025, 12:18

The Chancellor may have to raise taxes again or cut public spending as a result of the rising costs of government borrowing.

Borrowing costs rose to the highest level in 17 years amid a sell-off in the bond markets.

This could cut into the financial headroom that Labour could have to work with in a potentially worrying sign of how investors see fiscal sustainability in the UK.

This also contributed to a slump in the value of the pound, which dropped to its lowest level since 2023.

Sterling dropped by as much as 1.1% to 1.233 against the dollar on Wednesday.

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Former Cabinet Secretary Gus O’Donnell tells Andrew Marr that the government ‘will have to get very tight on spending’.

The yield on the benchmark 10-year UK gilt, which reflects the cost of government borrowing, climbed by roughly 12 basis points to a peak of 4.81%. It was the highest reading since the 2008 financial crisis.

The rise in gilt yields has an inverse effect on the price of these government bonds, which fell as a result on Wednesday.

The cost of longer-term borrowing also continued to rise, with the yield of 30-year gilts at their highest level since 1998.

They were up around 10 basis points to a peak of 5.36%.

Lord Gus O'Donnell, who served as cabinet secretary during the Blair, Brown and Cameron premierships, warned that the current Number 10 needed "more intellectual heft" and "economic expertise" to deal with the Spending Review.

"They are going to have to be very tight on spending. This is going to be a pretty brutal Spending Review. There are going to be lots of departments who are upset... but it's manageable," he told LBC's Tonight with Andrew Marr.

Asked if he believed Downing Street had the intellectual heft to deal with the review, he said: "The answer is no, and it's very clear. Who in No 10 has done a Spending Review before? I don't know of anybody.

"So, yes, they need more intellectual heft. They need more economic expertise."

Globally, there has been a wider sell-off in government bonds in recent months in the face of worries that US President-elect Donald Trump could introduce a tariff policy which would be inflationary for many international economies.

US Treasury yields also moved firmly higher on Wednesday, with the 10-year yield rising to 4.69% - its highest since April last year.

It came after reports of resilience in the US economy cast doubts over expectations for further cuts to interest rates.

In the UK, the rise in yields came as the Debt Management Office (DMO) sold £4.25 billion of notes on Wednesday, having sold £2.25 billion a day earlier.

Last year, the DMO said it expected to sell about £296.9 billion of notes over the 2024-25 fiscal year.

The rise in government borrowing costs poses a challenge for Chancellor Rachel Reeves, putting pressure on the Treasury's ability to increase public spending amid the prospect of higher interest costs.

After the autumn Budget, Ms Reeves was left with only £9.9 billion of headroom to meet her revised fiscal rules. This came despite a £40 billion package of tax increases to fuel higher spending.

Higher debt interest costs may mean the Chancellor would need to trim spending plans or bring in more revenue than expected to meet the fiscal rules.

Kallum Pickering, chief economist at brokerage Peel Hunt, said: "If bond yields rise further, Reeves may be forced to make the economically damaging decision of further increasing taxes or cutting back on planned public spending to balance the books."

The Chancellor committed last year to having only one fiscal tax-changing event a year.

The Treasury said she would leave "no stone unturned in her determination to deliver economic growth and fight for working people".

"No one should be under any doubt that meeting the fiscal rules is non-negotiable and the Government will have an iron grip on the public finances," a spokesperson said.

"UK debt is the second lowest in the G7 and only the OBR's forecast can accurately predict how much headroom the government has - anything else is pure speculation."

Expert calls Rachel Reeves' promise not to raise taxes again 'dangerous'

The Prime Minister's official spokesman said: "I'm obviously not going to get ahead... it's up to the OBR (Office for Budget Responsibility) to make their forecasts and they'll make their forecasts at the spring statement in the usual way.

"But I would say when the Government came into office we made very clear why it's so important to manage the public finances to deal with the £22 billion black hole that was in the public finances, because having stability in the public finances is precursor to having economic stability and economic growth."

Shadow chancellor Mel Stride claimed the Chancellor's spending and borrowing plans in the Budget are "making it more expensive for the Government to borrow".

"We should be building a more resilient economy, not raising taxes to pay for fiscal incompetence," he wrote in a post on social media.

"Labour's decision to allow debt to continue rising ever higher leaves us vulnerable even to small changes in markets."

Michiel Tukker, senior European rates strategist at ING, said it may take some time for borrowing costs to swing back lower.

He said: "Myriad factors contributed to the stretch higher, including Labour's spending ambitions, sticky inflation, higher US rates and supply pressures.

"We still see gilt yields settling lower later in the year, but as long as these factors linger, a change in direction may take some time."