Labour’s budget has given the bond market indigestion

If there isGDPOBROBROBROBRGDP one moment of Tory excess that the Labour Party has long sought to define itself against, it is Liz Truss’s in 2022. “Never again”, Rachel Reeves said solemnly in 2023, “will we allow a repeat of the devastation Liz Truss and the Tory party have inflicted on family finances.” Which is why the bond market’s sharp response to Ms Reeves’s , which she delivered on October 30th, is particularly tricky.Bond yields in Britain have been creeping up since mid-September but they were moving largely in lockstep with those in other rich countries. The 25-basis-point jump in ten-year gilt yields (see chart) that started after Ms Reeves had finished speaking and as traders processed the scale of her proposed boost to bond issuance and borrowing, was different and specific to Britain. Ms Reeves laid out plans for £70bn ($91bn; 2.6% of ) of additional annual government spending, of which £30bn or so would be covered by additional borrowing. She substantially loosened Britain’s fiscal rules to enable this, and then ran up close to her new limit.The market reaction has raised two questions. The first is what is driving the sell-off. Mostly, markets seem to have fretted that a hefty injection of fiscal stimulus into an economy that is already running hot would stoke inflation. That would, in turn, make the Bank of England more likely to keep interest rates higher than anticipated, driving down the price of existing government bonds. The Office for Budget Responsibility (), a fiscal watchdog, reckons that the measures in the budget will boost short-run inflation by around 0.4 percentage points; Goldman Sachs, a bank, raised its forecasts for core inflation (which excludes food and energy) by 0.2 percentage points. More mechanically, higher borrowing also increases the volume of bond issuance that markets must absorb; one way for markets to clear is through higher yields.A tug-of-war between monetary and fiscal policy is not ideal but it is also not that uncommon. Labour’s argument going into the budget was that by borrowing for investment, its spending would boost the supply side of the economy and so tamp down inflation. In the short run, this was never credible. Before projects can boost the economy they need to be built; doing so in a tight labour market will inevitably bid up wages and prices. The reckons that the growth benefits of public investment take between five and ten years to materialise.What made the market reaction to Ms Truss’s mini-budget so problematic was that a substantial risk premium—memorably dubbed the “moron premium” by one analyst—opened up for British government bonds as spooked international investors did not just reprice their expectations but fled gilts altogether. Britain is especially reliant on foreign debt-buyers to finance government deficits. One straightforward measure of the pain in 2022 was the value of sterling. All else being equal, higher interest rates should be a boon for a rich-world currency, but sterling crashed after the Truss mini-budget. This time, barring a troubling wobble on October 31st, there have been no such dramatic currency moves to follow Ms Reeves’s budget.Ms Truss triggered two particular bond-market horrors: the prospect of runaway inflation and of unchecked borrowing. Ms Reeves is doing much better on that front. Producing an expansionary budget at a time when British inflation has only just fallen back towards its target is a little reckless but nothing like Ms Truss’s choice to spray around stimulatory tax-cuts during an energy crisis. Whereas Ms Truss fired the top Treasury official and sidelined the , Ms Reeves worked closely with both bodies (although she was cavalier in dramatically loosening the definition of debt used in Britain’s fiscal rules after promising before the election that she would do no such thing).The second question is whether the chancellor could have avoided a bond-market adjustment. Pulling down the scale of borrowing would have helped, as would not front-loading the increases in the first few years of the forecast. Concentrated doses of stimulus are more inflationary and raise questions about the government’s capacity to deploy capital well and fast. But doing so would also have obvious political costs: for Labour to show voters tangible improvements in time for an election in 2029, it does pay for Ms Reeves to move quickly. Ms Reeves also doubtless suffered from the fact that investors’ patience was already frayed by the Truss episode.Above all, though, the rise in gilt yields crystallises the fact that Ms Reeves’s fiscal loosening entails some unavoidable trade-offs. For the public finances higher debt interest makes everything harder; the government already spends over 4% of each year servicing its debt. A higher and more expensive debt load will amplify that squeeze. Worse still are the consequences for business. British businesses already invest too little; higher gilt yields will flow through to higher borrowing costs for them, further weighing on investment. The government has spoken a lot about “crowding in” investment through vehicles like its National Wealth Fund; on this measure at least, private investment will be crowded out by its own borrowing. Households, too, will feel the impact of higher mortgages.Pain elsewhere in the economy could still be a price worth paying for higher public investment in Britain’s public services and infrastructure. The government would also argue that its plans don’t actually substantially increase public investment but merely stave off its predecessor’s unrealistic planned cuts. But the perils are real, too. If that money is not spent thoughtfully—and governments of all stripes have a sorry record of frittering away public money—the budget’s main effect will have been to set the economy back and remind Britain that borrowed money is not free.