Markets divided over Chancellor Reeves’ rumoured fiscal rule shift

Chancellor Rachel Reeves is likely to change the fiscal rules to allow billions of extra investment, reports suggest, a move which divided opinion among investors and economists.

According to a report in the Guardian, Reeves wants to change the rules so that the longer-term benefits of capital spending are accounted for in the fiscal rules. Prime Minister Keir Starmer refused to rule out such a change to the fiscal rules in PMQs this afternoon.

Depending on how the government wanted to measure these benefits, these changes could make space for between £50-60bn in extra borrowing. But some commentators warned that investors might be unwilling to digest this additional debt.

“The gilt market is likely to have an awful lot to say about all this additional borrowing and we expect gilts to continue to under-perform European government bonds in particular,” Lloyd Harris, head of fixed income at Premier Milton Investors, said.

“When you find yourself in a ‘hole’ (or a £22bn blackhole), you should stop digging!” he added.

Neil Wilson, chief markets analyst at Finalto, agreed that traders might not stomach the increase. The market is “going to look very very hard at this if they do it,” he said.

Wilson argued that a rapid increase in investment could lead to stronger growth at a time when the economy was still suffering from supply constraints. This could potentially keep inflation higher for longer, pushing up gilt yields.

Concerns about a big increase in borrowing have already filtered into the gilt market, with the cost of UK borrowing relative to Germany rising to its highest level in over a year.

However, it is still unclear exactly which fiscal rule Reeves will adopt. A more cautious option would be to tweak the debt measure to exclude losses from the Bank of England’s bond selling programme, a move which would increase the Chancellor’s headroom by around £16bn.

Gordon Shannon, portfolio manager at Twentyfour Asset Management, said that this reform would likely not spark a major panic in the bond market.

“The market can absorb this because time has been taken to sell the idea to the market and gauge reactions rather than dumping a surprise policy shift,” he said.

Shannon noted that it was “far less” than the sums which would be freed up by a move to measure the benefits of investment more comprehensively.

But James Smith, UK economist at ING, doubted there would be a major market dislocation, even if the government went for the most investment friendly fiscal rules.

Reeves is still committed to balancing the current budget, Smith noted, meaning the government could not increase borrowing for day-to-day spending or tax cuts.

He also doubted whether the government would use much of the extra space afforded by a change in fiscal rules. “The memories of 2022 are still etched into the political memory and the Treasury is going to tread carefully I suspect,” he said.

More prosaically, Smith noted that investment was “quite hard to deploy in practice” and so the government would face significant constraints on how fast it could get the money out of the door.

Reeves herself has previously said there needs to be “guardrails” around government spending decisions. “This is about making prudent, sensible investments for the long term,” she said in a recent interview.

A Treasury spokesperson said: “The Chancellor has said the Budget will be built on the rock of economic stability, including robust fiscal rules that were set out in the manifesto”.