Berenberg: Labour welfare row will lead to tax hikes and higher interest rates
Divisive party politics at the top of the Labour government stand to prevent the Bank of England from making further interest rate cuts, given struggles to curb spending, a leading City broker has warned.
The government is embroiled in another row over spending cuts, as £4.8bn in welfare budget savings look set to be watered down following a revolt by over 130 Labour backbenchers.
Corporate bank Berenberg has suggested that another U-turn on proposed spending cuts could force the Bank of England to keep interest rates higher for longer due to weak management over fiscal policy.
Its economist, Andrew Wishart, said the government’s stated commitment to keeping taxes stable and preventing too much borrowing “rings hollow” in the face of party backlash against some of the spending cuts.
The government’s failure to control public spending will either lead to higher tax rises than expected, Whishart said, which would “stymie business confidence”, or a rewriting of fiscal rules, which would “roil the gilt market” and lead to higher interest rates.
“Eliminating the structural fiscal deficit by limiting public spending is the best way forward: tighter fiscal policy would allow the Bank of England to cut interest rates more substantially and encourage a weaker pound, thereby supporting both business investment and demand for UK manufactures,” Wishart said.
“The growing risk is that Labour party politics prevent such a course of action.”
Labour battles with high cost of borrowing
The latest set of commentary from a top City firm signals concerns that the government’s dwindling authority over policymaking could both harm the UK economy and leave public finances on an unstable footing.
Debt interest payments for the financial year 2024-25 is expected to total £104.9bn, indicating the pressures Reeves faces due to the high cost of borrowing.
Should interest rates remain elevated, the cost of borrowing for the government would remain higher for a longer period.
Government expenditure on benefits for working-age people is projected to increase by some £26bn in the next five years, with Labour ministers determined to prevent the budget from becoming too hard to manage.
A vote on welfare reforms is scheduled for next Tuesday, with suggestions that the bill will be softened to ease concerns among Labour backbenchers.
It is unclear whether the government’s changes could lead to a fall in savings and undo cost reductions made ahead of the Spring Statement.
The Institute for Fiscal Studies (IFS) and City analysts have warned that the government will have to raise taxes to fund extra spending commitments on defence and infrastructure.
Economists at Capital Economics and KPMG have suggested that Reeves will have to find £20bn in extra receipts to restore her £9.9bn headroom, which is expected to be wiped out by the autumn,
The OECD has suggested that Reeves could adjust her fiscal rules and borrow more to fund spending pledges.