War in Iran erodes the chancellor’s headroom and exposes our fragility | Heather Stewart

Rachel Reeves boasts of the £23bn she has built up against her fiscal rules but now she – or any future steward of the economy – has little space to manoeuvre

It is with no pleasure that I must report a depressing domestic byproduct of the war in the Middle East: headroom chat is back.

Of course, shifts in investors’ appetite for gilts – UK government bonds – are trivial in the context of the bloodshed in Iran and beyond. But as a result of the economic chaos unleashed, gilt yields, which determine the interest rate on government borrowing, have resumed their grip on British politics. And one of Rachel Reeves’s proudest boasts, the £23bn in “headroom” she had built up against her fiscal rules, is in jeopardy.

Less than a month ago, the chancellor was able to stand up in the House of Commons and report that her headroom had increased since November’s tax-raising budget. Her (not unreasonable) hope was that this generous cushion would free her from minute scrutiny by bond investors, allowing her to spend the year focusing on conquering inflation and kickstarting growth. With both of those ideas now looking fanciful, however, Reeves’s financial breathing space is at risk once again.

Four weeks into the devastating conflict in the Middle East, the yield – in effect the interest rate – on 10-year gilts has surged to its highest levels since the global financial crisis of 2008, ending last week a whisker off 5%. That will push up the government’s cost of borrowing, and by extension the cost of just about everything it wants to do.

With oil prices up about 50% since the onset of the war, and the impact rippling out into other commodities, the jump in yields reflects higher expectations for inflation and interest rates. Investors who had been betting on further rate cuts in the UK have dramatically reversed course and now expect rates to rise twice or more this year as the Bank of England reacts to surging prices.

As several members of the Bank’s monetary policy committee seemed at pains to hint last week, the markets may have got ahead of themselves. Rate setters have to balance the risks of rising inflation against the weakness of the economy. But weaker growth, caused by the cost shock barrelling towards the UK economy, will also hit the Office for Budget Responsibility’s forecasts for tax and spend, which are highly sensitive to small changes in the outlook.

As Thomas Pugh, of the consultancy RSM, put it in a note last week: “The combination of higher inflation, weaker employment and surging gilt yields means the chancellor has probably already lost a third, or even half, of her headroom.”

The UK has not been the only country that has seen wild moves in the price of its bonds since the onset of war: Germany’s 10-year yield, or interest rate, which moves in the opposite direction from the price, is also up sharply, by almost half a percentage point, for example. Even with US Treasury bonds, usually seen as the ultimate safe haven, yields have risen, raising wider questions about the stability of the global financial system.

Yet the shift up in interest rates in the UK has been larger, at close to 0.7 percentage points. And the fact the government’s debt management office needs to sell £250bn worth of bonds this year – to borrow that much from investors, in other words – means no politician will have the luxury of ignoring the market.

So Reeves faces a repeat of last year’s corrosive speculation about what action she may decide to take in the autumn to keep her forecasts on track. And if a Labour leadership contest is triggered after the May local elections, candidates’ every pronouncement on tax and spend will be scored instantly by febrile markets.

The US hedge funds that are often the marginal buyers of gilts tend not to be experts in the minutiae of internal Labour party politics, but they don’t generally like uncertainty, or – as the Liz Truss farrago underlined – plans for massive unfunded splurges.

That doesn’t mean there is zero room for manoeuvre, but it does mean any shift in tax and spend would have to be carefully plotted out and explained, to avoid being swamped by surging interest rates set by global investors.

Perhaps it’s not surprising, then, that Angela Rayner has apparently been mooting the resolutely sensible John Healey as a potential chancellor – though the less radical any reset on economic policy, the less appealing the pitch may be to Labour MPs hungry for change.

Even for advocates of ditching the fiscal rules and replacing them with something more nuanced, the real-world challenges reflected in the UK’s high borrowing costs are inescapable. At the launch of a new green thinktank, Verdant, last week, its co-director, the leftwing economist James Meadway, conceded: “There isn’t, in fact, much capacity for the government – any government – in this country right now to borrow a load of money, or even worse to print a load of money.

“If you live in a country that has to import 40% of its food, 50% of the natural gas used to keep the lights on, 60% of the fertiliser, you have remarkably little room for manoeuvre,” he added – because the UK is so exposed to global markets, including, like it or not, for its debt.

The economic consequences of Donald Trump’s war will be a formidable headache for Reeves in the coming months, eroding her precious headroom. But the UK’s fragility in the face of this crisis will also raise urgent questions about the economic pitch of any other potential steward of the economy – inside Labour or out.