Chancellor John Healey’s Budget fiscal headroom is shrinking rapidly, economists warned on Friday, even as official figures showed the UK economy grew by 0.4 per cent in July, comfortably ahead of forecasts that had predicted flat growth. The good news from the summer may prove short-lived: a bond market sell-off has sent gilt yields to multi-decade highs, and energy prices are rising again.
Julian Jessop, economics fellow at the Institute for Economic Affairs, framed the GDP release in blunt terms. ‘The UK economy was still holding up better than most had expected in July, but this may just be the calm before the next storm,’ he said. ‘Unfortunately, any good news from two months ago is now being blown away by the fresh headwinds coming from energy prices and the bond markets. The UK economy is still lurching from crisis to crisis.’
A large part of July’s stronger-than-expected performance came from artificial intelligence and cloud computing firms, which recorded a surge in revenue over the period.
Gilt yields hit levels not seen since 2007
The bond market is where pressure is now most acute. According to Euronext, the yield on 10-year gilts peaked at 5.294 per cent on Wednesday, the highest since August 2007. BigGo Finance reported that 30-year gilt yields touched 5.89 per cent in the same sell-off, with 10-year yields reaching 5.25 per cent.
The pressure fed directly into the government’s own borrowing costs. London Loves Business reported that the government sold £900 million of 25-year index-linked gilts at a record yield of 2.496 per cent during the sell-off, underlining just how much more expensive debt servicing has become in a matter of weeks.
The fiscal consequences are substantial. Some economists had forecast that the £22 billion in fiscal headroom left by Rachel Reeves in her 2025 Budget could be as much as halved after gilt yields spiked. Deutsche Bank’s Sanjay Raja put a sharper number on it: he estimated that Healey’s headroom would shrink from £26 billion to £13.8 billion, according to BigGo Finance. That would leave precious little room for new spending commitments or tax relief.
Healey Budget fiscal headroom: tax rises looking harder to avoid
Yael Selfin, chief economist at KPMG, acknowledged that July’s figures would lend some support to the public finances going into the Budget, but cautioned against reading too much into a single month’s data. ‘With borrowing costs elevated and competing spending pressures remaining significant, difficult decisions on tax and spending are likely to remain unavoidable,’ she said.
Analysts have warned that Healey has little room for further borrowing and will be forced to raise taxes to stay within the fiscal rules, which require day-to-day spending to match receipts by 2030. The trajectory of gilt yields, if sustained, makes those constraints considerably tighter than they appeared even at the time of the last Budget.
Richard Carter, head of fixed interest research at Quilter Cheviot, offered a similarly cautious read of the GDP data. ‘Growth is going to be hard to come by so [July’s surge] may not last, especially as activity is likely to stall ahead of the Budget,’ he said. ‘Calls for pro-growth measures will get louder as the Budget nears, but whether or not the government has the room to act remains to be seen, especially if more tax levers are likely to be pulled.’
Healey points to G7 performance but flags Middle East risk
Healey, in his first major speech as Chancellor earlier in the week, said he would not ‘speculate on questions of tax’. Responding directly to the GDP figures, he sought to balance optimism with caution. ‘Britain’s economy is demonstrating a welcome resilience, despite serious global uncertainty,’ he said. ‘Our growth, although still fragile, was the fastest in the G7 in the first half of the year. But, the conflict in the Middle East does have impacts here at home, from the cost of the weekly family shop to the cost of government borrowing.’
Ongoing fiscal pressures linked to the US-Iran conflict have added to the strain on the public finances ahead of the Budget. With 30-year gilt yields at levels not touched in decades and Deutsche Bank estimating that Healey’s usable headroom has already been roughly halved, the Chancellor arrives at his first Budget with far less room than the summer data alone might suggest.
