Rachel Reeves warned of fiscal rules risk after growth downgrade

The OECD has warned UK Chancellor Rachel Reeves that her fiscal rules are at risk due to slowing economic growth, downgrading the UK's growth outlook to 1.3% this year and 1% next year, citing trade uncertainty and high interest rates; this follows a similar warning from the IMF and highlights the "thin" fiscal buffers of under £10 billion, increasing the risk of breaching deficit reduction targets if adverse shocks occur. The OECD advises strengthening public finances through targeted spending cuts, revenue-raising measures, and tax system reforms, while projecting the UK's budget deficit to shrink to 4.5% next year but debt to rise to 104% of GDP in 2026.

Analysis

The Organisation for Economic Co-operation and Development (OECD) has issued a significant warning to UK Chancellor Rachel Reeves, indicating a risk of breaching fiscal rules due to diminished growth prospects and minimal fiscal buffers. The OECD downgraded its UK economic growth forecast to 1.3% for the current year (from 1.4%) and 1.0% for the next (from 1.2%), attributing this slowdown to rising trade uncertainty, high interest rates, and declining household and business confidence. This caution, echoing a similar advisory from the International Monetary Fund, underscores the precariousness of the UK's fiscal position, with less than £10 billion in headroom to meet the primary rule of balancing day-to-day spending with tax revenues by parliament's end. The OECD projects the UK's budget deficit will narrow from 6% in 2024 to 4.5% in the subsequent year, driven by higher tax receipts; however, elevated market borrowing costs are expected to push the national debt to 104% of GDP by 2026. To mitigate these risks, the OECD recommends a balanced approach in the upcoming spending review and autumn budget, incorporating targeted spending cuts, closure of tax loopholes, revenue-raising measures like re-evaluating council tax bands, and broader tax system reforms. It also noted that supply-side reforms, such as overhauling planning policy, could alleviate fiscal pressures long-term. Concurrently, the Bank of England is anticipated to implement three interest rate cuts over the next year. This UK-specific pessimism from the OECD, reflected in a strongly negative sentiment score (-0.6), contrasts with somewhat more optimistic domestic forecasts from KPMG (1.2% growth this year) and the British Chambers of Commerce (1.1% growth), with KPMG highlighting potential benefits from a partial US trade deal. Globally, the OECD also revised down its growth forecast to 2.9% for the current year, with the US economy expected to slow to 1.6%.

Key Decisions for Investors

• Investors should exercise caution with UK-specific assets given the highlighted fiscal vulnerabilities and downgraded growth outlook, particularly monitoring for any adverse economic shocks that could rapidly erode the thin fiscal buffers.
• Closely scrutinize the forthcoming UK spending review and autumn budget for concrete measures towards fiscal consolidation or further spending pressures, as these will be critical indicators of the government's response to the OECD's warnings.
• Monitor leading indicators such as UK trade figures, interest rate movements, and business and consumer confidence surveys, as these will be key to validating or challenging the OECD's pessimistic growth trajectory.
• Consider potential for increased volatility in UK gilts and sterling, stemming from the diverging economic forecasts and the significant fiscal challenges outlined.