This isn't Truss 2.0 – but Labour should learn from her mistakes

It may not be fair to compare the gilt market turmoil of recent days with the bond crisis that brought down Liz Truss’s short-lived government. But dragging up the Truss episode has one significant benefit: this cautionary tale is a valuable warning for the new government on how control and credibility can be lost, and how it might be wrested back (by giving the market what it demands, rather than what the cabinet might wish for). 

Examined entirely without reference to the previous debacle, it is clear that the current situation is not unique to the UK and that governments everywhere are being forced by bond investors to pay more to borrow. Yields have risen in the US and Germany, too. It is therefore a broader repricing in the face of higher for longer interest rates, in a world awash with debt. But buyers of British gilts have extra reason to be picky and demand higher compensation for handing over their cash, with anaemic growth rates and expectations that businesses will increase prices to help pay for higher labour costs being additional unsettling factors. 

Deutsche Bank notes that the UK is not an outlier by any means when it comes to the government's net debt, its fiscal position and primary balance (ie the difference between revenues and spending outside of debt interest payments). It adds that all advanced economies face rising debt levels associated with the green transition and ageing populations. But it thinks the UK has moved to the top of the G7 leaderboard when it comes to the challenge of reducing debt as a share of GDP. 

Whatever the factors behind the sell-off, it presents a particular problem for chancellor Rachel Reeves should higher debt interest completely wipe out her thin spending headroom of just £9bn. This is the complication Reeves now has to solve, and it is one of her own making thanks to her high spending, inflationary minefield of an October Budget. Ambitious spending plans left only a third of the normal fiscal margin preferred by most chancellors, making policy revisions an ever-present risk. 

It is of course possible that with so many moving parts to the bond market, Reeves could, as the Institute for Fiscal Studies points out, get lucky. The government sells billions of pounds-worth of gilts every week and current high yields could draw an army of eager buyers, pushing the cost of debt down. Most economists expect yields to fall over the course of this year and Capital Economics thinks inflation will fall more quickly than most anticipate, allowing the Bank of England to deliver more rate cuts than anticipated. Indeed, stable inflation figures this week showing that consumer price index inflation last month dropped from 2.6 per cent to to 2.5 per cent are positive and could help restore the lost fiscal headroom, but it’s too early to take the downwards direction as a sure-fire guide for the year ahead.

If, by the time of the fiscal statement planned for 26 March, Reeves’ spare spending capacity remains threadbare and in breach of her own self-imposed fiscal rule designed to get debt falling, a mini Budget may be required. She would face a choice of cutting spending or raising taxes again, both of which would be unwelcome and risk becoming new headwinds for the economy. After all, part of the government’s plan for kickstarting growth is the additional spending of £100bn across public services as outlined in the Budget, although the Office for Budget Responsibility’s assessment has suggested any growth spurt might not last. If yields stay at levels reached earlier this week, Pantheon Macroeconomics estimates the chancellor would need to lower her planned spending in 2029-30 by £13bn (0.4 per cent of GDP) to maintain the fiscal headroom outlined in the October Budget.

If gilt yields do fall back, that will take the pressure off the chancellor and mean she can stick to the narrative that the government’s plans and projects (with a new growth plan to be revealed on her return from Davos) will deliver stability and growth during the course of this parliament, with assurance that cuts to spending will come if needed. 

This episode isn’t Truss 2 but it highlights deeper problems. The depressing possibility of fresh gilt market upheaval is not the least of the reasons why creating the right conditions to fire up growth must be the government's priority. It is essential to shunting Britain out of this era of low growth and high debt.