The UK Faces Its Worst Dilemma as High Borrowing Costs and Economic Struggles Persist

The UK’s economy likely shrank in the fourth quarter of last year, pushing the country to the brink of recession once again. This raises further pressure on Chancellor Rachel Reeves and her pledge to boost economic growth.

Economists estimate that under Reeves' tax-heavy budget, the UK’s GDP may have declined by 0.1% in Q4 2024 after stagnating in Q3. According to the Bank of England, the UK now faces a 40% chance of falling into a technical recession—two consecutive quarters of economic contraction—for the second time in just over a year.

With stagnating growth and rising cost-of-living pressures, Reeves is facing significant challenges ahead of next month's official economic forecasts. The Office for Budget Responsibility (OBR) is now expected to revise its projections downward, following the Bank of England’s lead.

Currently, Chancellor Reeves is on track to violate her fiscal rules. Unless the economic outlook improves, she may be forced to cut public services or welfare spending.

The UK’s Worst Dilemma

The UK’s borrowing costs resemble those of the fast-growing US economy, but its growth rate aligns more closely with the struggling Eurozone, where the European Central Bank has aggressively cut interest rates below UK levels. This situation makes stabilizing public finances particularly challenging for Reeves. Investors have grown increasingly uneasy about the UK's debt levels, which are now at their highest proportion of GDP since the early 1960s.

According to calculations by EY, the UK’s borrowing costs relative to nominal growth exceed those of most developed economies.

Ruth Gregory, Deputy Chief UK Economist at Capital Economics, warned:
"Unless the government finds a way to reduce its large primary deficit, concerns over public sector debt sustainability may intensify. There is absolutely no room for complacency."

The Office for National Statistics (ONS) is set to release Q4 GDP data on Thursday, alongside updated estimates for December 2024. Analysts predict that output stagnated in December, leaving the economy at the same size as when the Labour government took office seven months ago. Both consumers and businesses continue to bear the burden of the £40 billion ($49.5 billion) in tax hikes announced in the budget, alongside global risks such as tariffs imposed by US President Trump.

Some economists expect a mild economic rebound in Q1 2025, driven by government spending. However, they caution that a UK recession remains a real possibility. Before the data release, analysts noted:
"We were surprised by the recent weakness, and economic activity may continue to disappoint. This could push the UK into a technical recession this winter and prompt the Bank of England to reconsider its gradual rate-cutting approach."

Last week, the Bank of England struck a pessimistic tone, cutting its growth forecast for 2025 from 1.4% to 0.7% and warning that inflation could stay higher than previously expected due to rising energy prices. Governor Andrew Bailey signaled a "gradual and cautious" approach to further rate cuts, with money markets now expecting no more than two or three reductions this year.

Economic Growth Is Crucial for Labour’s Promises

For the Labour government to fulfill its election pledges on public services and investment, economic growth is vital.

Last month, Reeves promised to revitalize the weak economy by building new wind turbines, roads, airports, railways, and trade agreements. However, economists warn that such projects take time to materialize. As the OBR assesses economic conditions ahead of the March 26 Spring Statement, the Chancellor faces a critical test.

On Tuesday, the OBR lowered its UK growth forecast. Last week’s early estimates suggested Reeves is facing a slight deficit. The downgrade, combined with rising borrowing costs since October 2024, wiped out the £9.9 billion budget surplus that was intended to ensure tax revenues covered day-to-day spending.

Now, Reeves faces tough choices—potential spending cuts loom after she ruled out further tax hikes following backlash from businesses.

UK 10-year bond yields stand at around 4.5%, similar to those in the US. However, the growth gap is striking: the US economy expanded nearly 3% in 2024, fueled by strong consumer spending. In contrast, the Bank of England estimates UK growth at just 0.7%, mirroring the Eurozone, with no significant rebound expected until 2026.

Peder Beck-Friis, an economist at PIMCO, told the House of Lords Economic Affairs Committee last week:
"One key factor driving UK economic underperformance is the R-G (interest rate minus growth rate) equation. Compared to the UK’s economic growth rate, only Italy faces similar high borrowing costs.