Forecasters sitting in a small office at the top of the Ministry of Justice building have had their work cut out this week. A week from the Budget, the headquarters for the Office for Budget Responsibility, the independent fiscal watchdog, is likely to be buzzing with staff members double-checking details and estimates in its crucial economic and fiscal outlook that determines whether the Chancellor has a grip over public finances.
If researchers had only looked over data relating to the jobs market and growth, things could have been pretty positive. The unemployment rate fell to 4.7 per cent, defying expectations, while wage growth inched higher, likely boosting projected income tax levels. Consultants at Big Four firm EY said a faster drop in unemployment levels could deliver the Chancellor billions more in extra receipts and limit borrowing.
At the same time, the UK economy has beaten the naysayers and continued to grow. Budding productivity data over the last two years suggests that the country could be returning to the better days of the noughties where growth tracked at around two to three per cent, according to ex-Goldman economist Jim O’Neill, thereby giving John Healey a windfall worth billions of pounds.
On Wednesday, those rising hopes came crashing down. In a double blow, inflation rose higher than expected and government borrowing overshot the OBR’s forecasts for September.
Healey’s dilemma
In a major milestone for the course of public finances, UK debt has now surpassed £3 trillion for the first time. It took around 10 years for debt to rise from £1 trillion to £2 trillion between February 2010 and June 2020. After £385bn in spending for the pandemic plus extra borrowing to support households after Russia’s full-scale invasion of Ukraine, as well as looser borrowing rules to boost capital investment, it took six years for another trillion to be added to public sector debt.
Healey may be advised to look past the headline figure. As a share of GDP, debt has fallen slightly in the last 12 months. But a “dismal picture” has been drawn out in public finances data, as Ruth Gregory of Capital Economics said.
The government’s current fiscal problem, data shows, is not related to taxation. Analysis by the Resolution Foundation showed that receipts were nine per cent higher than the same month last year as stronger than expected growth had delivered a boost in revenue from corporation taxes. Receipts are running above OBR forecasts.
Rather, the government is spending more than it would like, primarily on welfare and on covering debt.
The Resolution Foundation noted that a near-£25bn deficit in September was partly driven by social benefits running at around £2.5bn above expectations. Greg Thwaites, interim chief economist at the think tank, said Healey faced a “dilemma” given public pressure to top up support for some families struggling with higher energy prices. He called for any new spending package at the Budget to be “targeted”.
The debt interest bill likely to worry the Treasury
In data that is more likely to concern Budget watchers across Westminster and the City, costs to cover high levels of public debt have also risen above expectations.
The Office for National Statistics said debt interest costs hit £10.9bn in September, a rise of around 17 per cent on last year’s figure. Debt interest costs were about £2bn above the OBR’s forecast. They are expected to rise above a peak seen in the current financial year of about £11.7bn.
This piece of statistics is poised to leave Treasury planners and government accountants on edge. It reflects a spike in gilt yields over the last seven months following the eruption of conflicts between Iran in the Middle East, pushing up government borrowing costs. Ten-year gilt yields rose from around 4.2 per cent to nearly as high as 5.5 per cent in this period.
The market-led rise is set to cost the Treasury billions. Healey’s main fiscal rule at the upcoming Budget states that spending on day-to-day operations such as staff wages should match tax receipts by 2030. As of March, his buffer against this rule stood at about £23.6bn.
The OBR states that each sustained percentage point increase in yields costs the government about £8.4bn more for the government by 2030. Along with a single percentage point increase in inflation and point rise in short term interest rate expectations, the total cost against the Chancellor’s headroom could reach £23.8bn, according to existing analysis provided by the fiscal watchdog.
City economists have widely predicted that the Chancellor’s headroom has dropped from over £23bn to about £12bn when income from extra receipts is taken into account. But a rise in gilt yields over the last few years could prompt the OBR to edge up its forecasts for debt interest payments over the next three years. Currently, the watchdog predicts costs to total just shy of £110bn this year, rising to nearly £135bn in 2030. City AM analysis shows that Labour has paid more than £200bn in debt interest costs since it was elected in 2024.
This puts the total for borrowing costs exceeding the combination of projected budgets for the Home Office, justice and defence in 2028-29. While the International Monetary Fund praised the UK government on its plans to reduce the deficit over the next few years, the ultimate arbiter will be the bond markets.
As the former Treasury economist Martin Beck said: “Unless the government gets serious about spending restraint, next week risks being little more than a stay of execution before another round of tax rises in 2027.”