Cuts, tax rises and doing nothing: Rachel Reeves’ options to tackle economic woe

London: Rachel Reeves is in a tough spot. The UK government is feeling the heat from a bond market sell-off and a falling pound. Investors are anxious, and they want reassurance about the country’s financial health.

After a rocky start in her role, Reeves has limited options due to Labour’s promises. There are a few measures the Treasury and the Bank of England could consider, depending on how things unfold in the markets.

Some analysts think Reeves might get a break. They believe the markets have overreacted to the current economic situation. It’s like they’re expecting the worst, but maybe it won’t be that bad after all.

The Office for Budget Responsibility (OBR) hasn’t yet gathered all the financial data it needs for its forecasts. They’ll do that closer to March 26, which gives some time for things to settle down.

Right now, the markets are anticipating two interest rate cuts from the Bank of England this year. But some experts think the outlook could worsen, leading to even more cuts in 2025.

Things could get trickier after Donald Trump’s inauguration on January 20. If he quickly imposes import tariffs, it could spark inflation.

A lot hinges on what happens around that date, according to Mohamed El-Erian, a former IMF deputy director.

The Treasury seems to be leaning towards spending cuts to stick to its fiscal rules. But that’s a tough sell for Labour, which promised not to return to austerity while trying to fix public services.

If the OBR’s forecasts show a breach of fiscal rules, cuts to capital spending on infrastructure projects could be on the table. Last autumn, the government planned to boost investment in transport and housing by £100 billion over five years. But that would clash with Labour’s goal of using investment to spur long-term growth.

Another option is to commit to deeper spending cuts beyond the current review period while increasing short-term spending. Reeves had proposed a 4.3% rise in day-to-day spending this year, but the Institute for Fiscal Studies warns that could lead to real-term cuts for some departments.

Martin Weale, a former Bank of England policymaker, thinks public spending cuts might be the least painful solution.

The big question is whether rising gilt yields will push the UK past its fiscal limits when the OBR updates its forecasts in March.

Raising taxes is another option, but businesses are already upset about the national insurance hike from Reeves’ November budget.

El-Erian suggests that increasing VAT and income tax, especially for the wealthy, could be the way to go. But Reeves has ruled out further tax hikes.

Ashley Webb, a UK economist, says Reeves has several paths: reversing her tax promises, creating new levies, or tweaking existing plans. This could involve changes to capital gains tax, alcohol and tobacco duties, and more.

The Bank could help calm the situation by signaling a willingness to cut interest rates. Currently, markets expect two cuts to 4.25% this year, which is less than what some investors anticipated last year.

The next rate-setting meeting is on February 6. If the Bank shows it’s ready to cut rates faster than expected, it could ease the pressure on the gilt market.

However, rising government borrowing costs could weigh on the economy, making cuts more likely. A weaker pound might drive up inflation, making the Bank hesitant to act.

In extreme cases, the Bank could opt for an emergency rate cut, but that might cause more panic than relief. The last time they did this was during the early days of the Covid pandemic in 2020.

The Bank’s deputy governor, Sarah Breeden, reassured that they’re monitoring the situation closely. So far, things have been orderly, and they’re committed to gradual rate cuts.

After Liz Truss’s mini-budget caused chaos in the bond market, the Bank had to step in. But analysts say a similar intervention now seems unlikely.

El-Erian noted that this isn’t a repeat of the Truss situation. The rise in yields has been slower and more controlled.

Darren Jones, the chief secretary to the Treasury, mentioned that the gilt markets are stable, suggesting no need for emergency measures.

Weale believes the Bank won’t buy government stock just to lower long rates, as that could backfire.

His advice? Do nothing for now and wait for the OBR’s forecasts in March.