More inflation and bond market turmoil ahead if Reeves relies on tax hikes, ALEX BRUMMER warns

Labour’s ambition to make Britain the fastest-growing economy in the G7 is a noble cause.

After all, not just working people, but the whole nation, would benefit from faster output, not least the public finances.

But league table economics also throws up unwanted results. The latest IMF economic forecasts show the UK is top of the league for average inflation at 3.4 per cent this year. The Government also has the highest bond yields.

The yield, or return on Britain’s 30-year long bond, stands at 5.32 per cent in latest trading. 

It is below peak levels, as is the ten-year offering a 4.48 per cent return. But it only requires one adverse set of inflation data, bad fiscal numbers or a bout of political uncertainty to push bond rates into the danger zone.

Bond vigilantes, the hedge funds and traders, are constantly on the look out for vulnerabilities. 

In focus: The latest IMF economic forecasts show the UK is top of the league for average inflation at 3.4 per cent this year

When they really get stuck in, they can effectively remove governments. It is the reason why Liz Truss’s government remains such a potent symbol of failure.

Britain’s outsized inflation and excessive bond yields have both triggered concern at the IMF. Investors in gilts seek higher returns in an inflationary environment.

This is highly relevant to the unpopular Office for Budget Responsibility as it finalises its Budget projections. 

The higher the bond yields, the bigger the projected interest rate bill and the less cash for public services. 

The UK’s inflation story stretches back to the pandemic. The combination of higher energy bills and a tight labour market created more inflation than in other G7 nations.

Then in 2024, regulated prices – particularly energy bills – were allowed to rise. 

Green levies and the drive for Net Zero almost certainly played a part. 

The concern, as far as the IMF and interest rate setters at the Bank of England are concerned, is that elevated prices have second-round effects.

When prices jump – and there have been increases across the board, including in shopping baskets – the public’s inflationary expectations also rise. That can drive up wage demands and costs and becomes difficult to combat.

Working in the Bank’s favour at present is a slowing jobs market which removes some of the upward pressure on pay.

Rachel Reeves’ intention to bear down on regulated prices is not favoured by IMF economists. It causes economic distortions, encourages subsidies and has negative fiscal impacts. It does nothing to resolve the underlying problem.

Clearly, the UK’s recent inflation record is a concern for bond markets. The modest size of the gilts market, compared to say that for American treasuries, also makes it vulnerable to volatility.

Britain historically had a low debt-to-output ratio. 

That started to change with the great financial crisis and zoomed up to near 100 per cent of GDP subsequently as a result of the pandemic and Ukraine energy interventions. 

The markets also have recognised that Labour’s fiscal rules aren’t working. Reeves’ goal was to ramp up capital spending. 

But in splurging the cash on airport runways, rescuing steel plants and other causes, she failed to leave herself enough fiscal space in current Budgets.

The emptying of the ‘headroom’ has offered a haven for speculation by the vigilantes. She could fix it in the Budget by slashing welfare bills.

That is politically unlikely. If the Chancellor relies on higher taxes, which raise business and consumer costs, the consequences will be more inflation and a ferociously turbulent bond market.

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