Britain's debt squeeze tests the pound’s power

Rising borrowing costs and persistent inflation are narrowing the UK’s fiscal room for manoeuvre, exposing the limits of monetary independence

Reuters

The UK's Chancellor of the Exchequer John Healey carries the traditional red budget box as he leaves Downing Street in London on 28 October 2026.

Britain's debt squeeze tests the pound’s power

Abdulfattah Khattab

last update on 10 Nov 2026

As European economies contend with rising borrowing costs and sluggish growth, the United Kingdom faces a difficult fiscal balancing act. It has its own currency and an independent central bank, yet carries a heavy burden of public debt, mounting debt servicing costs, and increasingly limited room for fiscal manoeuvre.

But does control over its own currency give the UK greater freedom to weather economic shocks than France, or do rising government bond yields expose the limits of monetary sovereignty, even for countries with their own currency? The answer lies in the distinction between having the tools to shape economic policy and being able to deploy them without fanning inflation, weakening growth, or undermining confidence in the public finances.

Chancellor of the Exchequer John Healey has opted to use part of the government’s fiscal headroom to cushion the economy against external shocks, rather than resort to sweeping tax increases or spending cuts. However, he has acknowledged that rising borrowing costs have made it harder for the government to abide by its fiscal rules.

According to the Office for Budget Responsibility (OBR), the government’s projected fiscal headroom against its current budget surplus target has fallen to £15bn in the 2029–30 financial year, down from approximately £24bn in its March forecasts. It is expected to recover to £22bn for the 2030 in 2030–31.

This headroom does not represent money freely available for government spending. Rather, it is the margin between the fiscal forecasts and the minimum level of surplus required to meet the government’s fiscal rule, and a slowdown in growth or higher financing costs could quickly erode this headroom. The OBR puts the probability of meeting the current budget surplus rule at just 56%, down from 59% in the 2025 budget, reflecting the uncertainty surrounding the government’s projected fiscal position.

Also impacted are the costs of the Bank of England’s quantitative tightening programme. Since 2022, the bank has been gradually reducing its holdings of bonds purchased under its earlier quantitative easing programme.

AFP — People walk along the River Thames, with the City of London business district visible in the background, on 13 February 2025.

As interest rates have risen, the interest the bank pays on commercial banks’ reserves has increased, at times exceeding the income generated by some of the bonds in its portfolio. It has also incurred losses from selling bonds for less than their redemption value. Under an indemnity agreement between the bank and the treasury, these losses are borne by the treasury, adding to the pressure on the public finances and leaving the budget increasingly exposed to fluctuations in interest rates and bond yields.

Nevertheless, the government expects borrowing to decline gradually. Public sector net borrowing is projected to fall from approximately 4.4% of GDP in 2025–26 to 1.8% in 2030–31, where it is expected to remain in 2031–32. A reduction in annual borrowing, however, does not necessarily translate into an immediate or comparable decline in the accumulated debt.

According to the OBR, public sector net debt is expected to peak at 97.3% of GDP in 2028–29 before declining to 95.6% in 2031–32. Public sector net financial liabilities, meanwhile, are projected to reach 83.8% of GDP in both 2027–28 and 2028–29, before easing to 81.7% in 2031–32.

These differing trajectories underline the importance of distinguishing between different measures of public indebtedness. Reducing the annual deficit alone is insufficient to bring down the accumulated debt burden, particularly when growth remains weak and financing costs stay high.

Key indicator

Economic growth will be decisive in determining whether the government’s fiscal plan succeeds. The OBR put its 2026 GDP growth forecast at approximately 1.25%, while lowering its 2027 projection to 1%, half a percentage point below its previous estimate. It attributes the downgrade to higher energy prices and borrowing costs, both of which are weighing on consumption and investment.

The renewed rise in inflation further complicates the outlook. Consumer price inflation reached 3.5% in the 12 months to September, up from 3.1% in August, driven largely by higher fuel and utility costs. The OBR expects inflation to average around 3.4% in 2027, reaching a quarterly peak of approximately 3.8% early in the year before returning to 2% during 2028.

AFP — A BP petrol station in Fenay Bridge, near Huddersfield in northern England, on 23 October 2026.

Furthermore, higher energy prices erode households’ real disposable incomes, increase government expenditure on welfare benefits and pensions, and raise the cost of inflation-linked government bonds. The OBR has warned that real disposable income per person will decline in the near term, with the projected level in 2030–31 falling below its March estimate.

The government now has to contend with competing demands, including restraining expenditure, protecting households and public services, and avoiding measures that could further weaken growth. If economic performance proves weaker than anticipated, tax revenues could fall, and the remaining fiscal headroom could erode before the deadline for meeting the fiscal rule.

The pound’s independence

One of the UK’s principal institutional advantages is its retention of the pound sterling and the Bank of England’s operational independence over monetary policy. This allows interest rates to be adjusted in response to domestic inflation and economic conditions. France, by contrast, operates under a common monetary policy set by the European Central Bank (ECB), which must balance the differing economic circumstances across the eurozone.

Monetary independence gives the Bank of England no licence to disregard inflation or cut interest rates without considering the consequences for prices, the exchange rate and market confidence. A flexible exchange rate can help cushion the economy against external shocks, although a depreciation of sterling could make imported goods and energy more expensive, slowing the pace of disinflation.

The OBR has warned that the public finances are highly sensitive to changes in interest rates, energy prices, and productivity

The ECB, for its part, has instruments at its disposal to intervene in bond markets. Among them is the Transmission Protection Instrument, which allows it, subject to specific conditions, to purchase government bonds on the secondary market. The aim is to counter unwarranted rises in borrowing costs that threaten the transmission of monetary policy across eurozone member states.

Fiscal policy nevertheless remains decisive in both countries. The UK can issue debt in its own currency, reducing its exposure to the risks associated with borrowing in foreign currencies. But this does not guarantee cheap financing. If inflation expectations rise or investors lose confidence in the government's ability to control debt and maintain sustainable public finances, borrowing costs can still increase.

Denominating debt in the national currency reduces the risk of nominal default, although the UK remains vulnerable to the pressures of financial markets. Monetary expansion or excessive borrowing could fuel inflation and erode the currency's real value. Unless accompanied by productivity-driven growth and credible fiscal and monetary management, such policies could weaken investor confidence. Investors may consequently demand higher yields on government bonds to compensate for inflation risks and the diminishing purchasing power of their investments.

Different constraints, similar risks

France offers a clear illustration of the pressures that heavy public debt can exert amid political paralysis. On 22 October, the yield on French 10-year government bonds reached 5.14%, while the spread over comparable German bonds widened to 177.7 basis points. By early November, however, the gap had narrowed to approximately 161 basis points, with French yields easing to around 4.9 to 5%. The figures show that investors were demanding a higher return to lend to the French government than to lend to Germany, reflecting concerns about France's political and fiscal outlook.

Reuters — The Palais Brongniart, former home of the Paris Stock Exchange, at Place de la Bourse in Paris, France, on 4 April 2025.

The UK is not necessarily in a stronger fiscal position. Yields on its 10-year government bonds stood at approximately 5.18% on 2 November, having exceeded 5.3% in late October. These persistently elevated yields reflect the high cost of borrowing in financial markets. They also show that a national currency offers no immunity from investor pressure when concerns mount over inflation and the sustainability of public debt.

These movements highlight the importance of factors shared by both economies: inflation, interest rates, the scale of public debt, and investor confidence. Differences in monetary arrangements alone do not determine a country's ability to withstand economic shocks. Even a country with monetary independence may face higher bond yields if its inflation outlook or debt trajectory gives investors cause for concern.

The OBR has warned that the public finances are highly sensitive to changes in interest rates, energy prices, and productivity. A one-percentage-point rise in interest rates could increase debt servicing costs by approximately £16bn. Meanwhile, deviations from projected productivity growth could alter borrowing requirements by tens of billions of pounds.

An increase of 0.5 percentage points in productivity growth relative to forecasts could reduce borrowing by around £50bn. By contrast, an equivalent shortfall could increase borrowing by approximately £40bn. Persistently higher energy prices could add £17bn to borrowing in the 2027–28 financial year.

Should interest rates rise or the economy slow, the government may find itself compelled to raise taxes or cut expenditure. Its options would narrow further if weak growth coincided with another sharp rise in energy prices. This would squeeze household finances and fuel inflation, constraining the Bank of England's ability to reduce interest rates.

The bank's decision on 5 November illustrated this dilemma. It raised its base interest rate from 3.75% to 4%, its first increase in more than three years, after inflation reached 3.5% in September. Price pressures were also forecast to push inflation to around 5% by mid-2027, driven by rising energy prices.

The decision did not necessarily signal the beginning of a sustained cycle of monetary tightening. Rather, it was a precautionary response to the risk of inflation becoming entrenched, particularly if higher energy costs began feeding through into wages and other prices.

All nine members of the Monetary Policy Committee voted to raise interest rates, although they differed over the size of the increase. Eight supported a rise of 25 basis points, while one member, the American economist Catherine Mann, favoured a larger increase of 50 basis points.

The economic costs of this decision extend beyond the immediate burden on borrowers. Higher interest rates increase mortgage repayments and debt-servicing costs for households and businesses. This can dampen consumption and investment, particularly when real incomes are already under pressure from rising energy prices. They can also increase government borrowing costs as new bonds are issued and maturing debt is refinanced, adding to the budgetary burden through higher interest payments.

UK government bond yields rose following the decision, while financial markets revised upwards their expectations of further rate rises. By the end of 2027, markets were pricing in approximately 76 basis points of additional monetary tightening, compared with around 67 basis points before the announcement. The future course of interest rates will depend on how long the external shock persists and how extensively its effects are transmitted through the domestic economy.

Fiscal discipline alone will not suffice

The UK government is seeking to reconcile fiscal discipline with investment. Yet investment commitments alone do not guarantee stronger growth. They must translate into higher productivity and, ultimately, increased tax revenues.

The OBR identifies weak productivity as one of the greatest sources of uncertainty in its forecasts, noting that even a modest improvement could significantly change the projected path of public debt and borrowing.

If the anticipated improvements fail to materialise, the government could find itself confronting persistently high debt, sluggish growth, and little room for further fiscal manoeuvre. Any substantial deviation from projected growth or inflation would require a reassessment of fiscal policy and could make compliance with the government's fiscal rules increasingly difficult.

More importantly, bringing the deficit under control does not, in itself, guarantee lower public debt or improved living standards. The challenge is to balance fiscal credibility with productive investment.

The October budget highlights the distinction between monetary independence and genuine economic resilience. Control over its own currency gives the UK flexibility in responding to economic shocks, but the lasting strength of its position will depend on restoring growth, improving productivity, and maintaining investor confidence. The government's limited fiscal headroom leaves limited room to absorb unexpected economic or financial shocks without risking compliance with fiscal rules.

The UK's success depends not only on retaining monetary independence, but on using that flexibility to support sustained economic growth, improve productivity, reduce the debt burden, and rebuild the fiscal headroom needed to withstand future shocks.

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