Downgraded Economic Outlook

britain’s Office for Budget Responsibility (OBR), the nation’s self-reliant budget watchdog, delivered a sobering assessment, halving its economic growth forecast for 2025. Further complicating matters, the OBR projected that any economic recovery later in the decade would fail to fully compensate for the initial slowdown. The watchdog also revised upward its forecasts for both public borrowing and inflation, painting a concerning picture of the U.K.’s economic future.

Reeves attributed the economic downgrade to “a changing world,” specifically citing the ongoing war in Ukraine and pervasive uncertainty impacting the global economy. She emphasized the potential fallout from former President Trump’s proposed trade tariffs, suggesting they could destabilize international markets. The global economy has become more uncertain,bringing insecurity at home as trading patterns become more unstable and borrowing costs rise for many major economies, Reeves stated.

However, the OBR also pointed to domestic factors contributing to the economic slowdown. They noted that an increase in employer taxes, previously announced by Reeves in October 2024, would likely dampen wage growth for British workers starting next year, further hindering economic expansion. This internal pressure adds another layer of complexity to the challenges facing the U.K. economy.

Fiscal Maneuvering and Future challenges

Despite the bleak economic outlook, Reeves asserted her commitment to maintaining her budgetary plans, taking steps to replenish a nearly 10 billion-pound fiscal buffer. This buffer had been significantly depleted in a mere five months due to the weakening economy and rising borrowing costs.thes fiscal rules are non-negotiable.They are the embodiment of this government’s unwavering commitment to bring stability to our economy, she declared, highlighting the importance of fiscal discipline during her speech, which heavily emphasized increased defense spending.

One of Reeves’ key fiscal objectives is to balance day-to-day public spending with tax revenues by 2030. To stay on track, she reduced the planned growth in day-to-day spending on public services from 1.3% to 1.2% annually in real terms. Additionally, the Labor government announced 4.8 billion pounds in cuts to welfare payments, a move that sparked considerable controversy and dissent within the party.

Following the government’s announcement of slightly lower-than-expected debt issuance over the next year, British government bond prices experienced a slight rebound after an initial dip. However, the long-term economic outlook remains uncertain.

“Kicking the Can Down the Road?”

Shamil Gohil, a fixed income portfolio manager at Fidelity International, offered a critical perspective on Reeves’ budget adjustments. The chancellor has replenished the fiscal headroom…which may provide some relief in the short term, but this is a temporary fix, kicking the can down the road, Gohil said. He further cautioned that Longer term, budgetary challenges remain as higher interest rates and weaker growth persist.

The 9.9 billion-pound fiscal headroom,the margin by which the government is meeting its fiscal rules,remains historically low and vulnerable to economic shocks or further increases in borrowing costs. The OBR estimates that Reeves’ announced measures would improve the balance of day-to-day spending against revenues by 14 billion pounds in 2029/30.

Adding to the uncertainty, the OBR underscored the potential for a U.S.-led trade war to severely impact the British economy. Specifically,they modeled a scenario in which the U.S. imposed a 20 percentage-point increase in tariffs on all its trade partners. In this scenario, the U.K.’s economy would be 1% smaller than the central forecast in the peak year of impact, 2026-27. The potential for such sweeping tariff measures, reminiscent of the protectionist policies considered under the previous Trump administration, highlights the vulnerability of the U.K. economy to external shocks.

Former president Trump is scheduled to announce on April 2nd his decision about whether to impose reciprocal tariffs on partners.

Tax Hikes on the Horizon?

The OBR also projected that Britain’s government is set to borrow 47.6 billion pounds more by the end of the decade than it had anticipated just five months prior.This increased borrowing could put further strain on the U.K.’s public finances.

If things go badly with the economy and the public finances, then the Chancellor will be back to square one, perhaps with a need to tighten spending again or perhaps tax increases or even a combination of both, warned Philip Shaw, chief economist at bank Investec.This assessment suggests that the U.K. government may have limited options if the economic situation deteriorates.

Reeves and Starmer, leaders within the Labour government, pledged to voters last year that they would not raise income tax or other major revenue-generating taxes. However, faced with economic pressures, they may consider extending a freeze on the thresholds at which people begin paying basic and higher rates of income tax. This strategy, previously implemented by the Conservative government, effectively draws more individuals into the tax net without explicitly raising tax rates. Such a move could prove politically contentious but may be viewed as a necessary measure to stabilize public finances.

Liam O’Donnell, a fixed income manager at Artemis Fund Managers in Edinburgh, highlighted investor concerns regarding the pace of borrowing in the U.K., particularly given the country’s elusive economic growth. I think the market is going to settle on expecting tax hikes for the autumn, O’Donnell predicted.These comments underscore the growing expectation among market participants that the U.K. government will ultimately resort to tax increases to address the country’s fiscal challenges.