Last week’s escalating tensions between Iran and Israel, leading to reciprocal strikes on major Gulf gas facilities, have dramatically driven up energy prices. These events have not only set refineries ablaze but have also metaphorically ignited concerns over Britain’s fiscal stability. During a diplomatic visit to Madrid, Rachel Reeves witnessed the unraveling of her ‘ironclad’ fiscal strategies amidst this turmoil.

In a unique position among leading global economies, the UK’s public finances, under the Chancellor’s stewardship, remain vulnerable to external shocks like the current spike in oil and gas prices, triggered by the conflict involving Iran.

As the Middle Eastern conflict stretches into its fourth week, there is increasing pressure for a new energy subsidy to mitigate the impact of rising fuel costs on households. According to Cornwall Insight, the typical dual-fuel household could see an increase of £332, pushing annual bills to £1,973 when the energy price cap is reassessed in July.

The prolonged nature of the Middle Eastern war threatens to drive inflation higher across the board, affecting everything from grocery prices to airline tickets, which could compel the Bank of England to raise interest rates.

Millions of borrowers and mortgage holders may face up to four interest rate hikes this year, potentially elevating the base rate to 4.75 percent. This figure comes close to the 5.25 percent peak reached in 2023 when the Bank of England battled double-digit inflation.

Amidst these daunting prospects, financial markets are responding. On Friday, investors sold off government bonds, reacting to alarming February data that showed a significant increase in government borrowing and debt interest expenses.

Debt bomb: Chancellor Rachel Reeves is under mounting pressure from MPs

The yield – or interest rate – charged on ten-year gilts leapt above 5 per cent for the first time since the 2008 financial crisis (see graph). Worse, the size of the national debt relative to the output of the economy, or gross domestic product, has doubled in the past 18 years, making the debt burden much greater.

The bond sell-off was a damning verdict on the anaemic state of the economy under Reeves. She is the guardian of the public purse, but it is in a particularly poor position to weather the gathering storm – let alone dispense more handouts.

Despite clobbering firms and families with huge tax rises, the Chancellor’s decision to borrow more to pay for higher welfare costs has left her with little wiggle room to meet her own fiscal rules.

These include matching day-to-day spending on public services with tax receipts by the end of the decade to keep febrile financial markets on board. But after increasing the headroom, or safety buffer, in her last Budget, Reeves still only has £24 billion to play with – a historically low amount.

That is only half the cost of the energy price guarantee introduced by the Tory Government after Russia’s invasion of Ukraine in 2022 sent prices rocketing.

‘The fragility of our economy is about to be exposed,’ Shadow Chancellor Sir Mel Stride told The Mail on Sunday. Richard Hughes, ex-boss of the Office for Budget Responsibility, recently told MPs Reeves’ rules were ‘among the loosest’ since they were introduced in 2010 to curb debt-fuelled spending and had ‘done little’ to build fiscal resilience. He also suggested the buffer should be over £50 billion to give the Treasury more space to respond to shocks.

The rising cost of servicing the Government’s huge debt is already gnawing away at that wafer-thin buffer. If higher borrowing costs persist into the autumn they would shrink that headroom by £10 billion, said Dennis Tatarkov, senior economist at accountant KPMG.

Reeves is also under pressure to perform another U-turn by scrapping a planned 5p a litre rise in fuel duty from September, which would prove popular with motorists already facing higher prices.

But extending the fuel duty freeze would bring the total cost of taxpayer support for drivers to £150 billion since it was introduced in 2011, according to Gideon Salutin of the Social Market Foundation think-tank. He added: ‘Should the Chancellor maintain fuel duty’s frozen level, she will bake in nearly £17 billion in more losses over the next four years.’

Such a hit to the public finances would hole the Chancellor’s fiscal rules below the waterline and cast further doubt among the investors who lend to Britain about its ability to pay its way in the world.

And that’s before the planned increase in defence spending.

One ‘known unknown’ is sterling. So far it has held up fairly well at about $1.34 against a resurgent dollar, which has rallied across the board as investors seek a safe haven from the Gulf storm.

But traders have been steadily ramping up their bets against the pound to levels last seen just before the disastrous Liz Truss mini-Budget in 2022, when a run on sterling saw its value sink almost to parity with the US dollar.

If they are right and the pound weakens again it would mean higher import prices. That would fuel inflation and be likely to lead to even steeper borrowing costs for the Government, businesses and households as interest rates rise to combat higher import costs.

But some experts think a repeat of 2022 – when the value of UK assets such as sterling and gilts collapsed in tandem – is unlikely.

‘The Persian Gulf and Strait of Hormuz are critical for global energy supply, but not freight or manufactured goods,’ said Andrew Wishart, economist at investment bank Berenberg. ‘Measures of container shipping and bulk shipping costs are steady.’

They soared after Covid restrictions were eased. And since then the number of job vacancies has halved while unemployment has risen from 1.3 million to 1.9 million, reducing the risk of another wage-price spiral, Wishart said.

Even so, he has cut his UK growth forecast this year from 0.9 per cent before the war to 0.6 per cent due to the energy price rise.

This is based on the Bank of England keeping interest rates on hold at 3.75 per cent, but he warned: ‘If it instead raises them, as investors expect, a recession would become a serious possibility. In that case, without spending cuts or further tax hikes the Government would surely miss the fiscal rule in the Budget forecast in the autumn.’

The Treasury said: ‘We have the right economic plan and that includes this Government’s commitment to its non-negotiable fiscal rules being ironclad.’

Reeves may still buckle to her backbenchers baying for bailouts by bending the fiscal rules again, but financial markets are unlikely to be impressed. They are already demanding more for lending to Britain than to any other advanced economy and at levels well above those of the Truss era. It seems the moron premium for perceived inept economic policies is back with a vengeance.

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