The dust has now settled on Rachel Reeves’ first Budget, but it was a consequential event to which it is worth returning.
A Budget has to speak to different audiences, and the Chancellor would have known she had difficult messages to deliver to both the wider public and the business world. Employers, predictably enough, are unhappy with the significant increase in employers’ National Insurance contributions. Reeves wouldn’t have expected the general public to be thrilled with higher taxes either, but if anything the reaction has been more muted than she might have feared. This might reflect well on the public’s realism (recognising that taxes were always going to go up) or badly on its understanding of the tax system (it will be workers who ultimately bear the burden of higher employers’ NICs). Either way, Reeves will feel relatively relieved on this point.
But there was another audience that had a more adverse reaction than she would have hoped: the bond markets.
It is worth quickly clarifying that the reaction of the markets to the Budget immediately after the speech and over the following day was not by any means a repeat of the 2022 mini-Budget. Gilt yields rose as analysts examined the Office for Budget Responsibility’s assessment of the fiscal situation, but nothing like the extent that they did two years ago. Rather than view these movements as a fundamental loss of trust in the government, they can be interpreted as a natural market adjustment to an environment in which interest rates will fall more slowly than previously expected.
Having said that, it was clearly not Reeves’ desired intention for the market reaction to be as pronounced as it was. For a Chancellor who has defined herself against Liz Truss and Kwasi Kwarteng, even the hint of a comparison must be painful. Matters stabilised on Friday, but Thursday was uncomfortable and it was unusual for her to request an interview with Bloomberg so that she could go out and reassure the markets.
Three aspects of the Budget may have caused limited disquiet. Most fundamentally, a fiscal loosening at the beginning of a parliament, when political pressures are at their weakest and there is little spare capacity in the economy, suggests it will be matched by a tighter monetary policy. In other words, interest rates will be higher than previously expected. This has a negative impact on mortgage holders and creates a further pressure on the public finances as debt interest costs increase.
More specifically, the spending plans involve a front-loading of increases followed by a tighter approach subsequently. Some will assume that tight spending increases in the run-up to a general election are unlikely and that a further fiscal loosening could be on the cards.
The final point is that – for a government that vowed to prioritise higher economic growth – there was relatively little about this in the Budget. Certainly, there was nothing there that impressed the OBR when drawing up its growth projections.
But, uncomfortable though the rise in gilt yields may have been, from a Treasury perspective the suggestion of bond market wariness might be something of a well-disguised blessing in the medium term.
Spending departments will be preparing their arguments for why the initial surge in spending should be maintained in the latter half of the parliament. The political case for this is self-evident and this matter will come to a head in advance of the comprehensive spending review next spring.
The Treasury will argue that departments should make use of the relative generosity of their settlements for the next two years to act strategically to reduce demand for services and/or improve productivity. The Chancellor and her chief secretary, Darren Jones, can now also make the point that there is no easy way to increase spending beyond existing plans without provoking a further market reaction.
Last week’s events also strengthen the case for a greater focus on economic growth. Ministers point to maintaining high levels of public sector investment as an example of long-term thinking. This is true but for the most part this additional investment has been directed at improving public services or obtaining net zero. These are worthy objectives, but if the sole priority had been increasing economic growth, different choices would have been made.
It is true to say that many of our problems with our public finances stem from low levels of economic growth which, in turn, stem from low levels of productivity. There has been a tendency on the left to believe that these problems could be easily resolved by stimulating demand through a looser fiscal policy, higher levels of public investment and by ending the Tory psychodrama.
The lesson from last week is that life is more complicated than that, something the government should now appreciate. There is currently no scope for a looser fiscal policy without a tighter monetary policy, higher public investment will not necessarily have a transformative impact (especially if unfunded and not carefully directed) and not every problem the country faces can be attributed to the dysfunctional nature of the modern Conservative Party.
No great damage was done by last week’s rise in gilt yields, but it was a reminder that the bond markets are watching us closely. If the lesson the government learns from this is that it must maintain fiscal discipline and pursue supply-side reforms that improve productivity and economic growth, this will be no bad thing.
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