Why fiscal rules matter

The upcoming Budget will test the government’s ability to balance fiscal credibility with economic support. With inflation still around 4% and the Bank of England cautious about cutting rates, the Chancellor faces tough choices.  

Fiscal rules are the financial guardrails a government sets for itself to manage public finances responsibly. Think of them as a self-imposed code of conduct, specifying limits on borrowing, spending and debt levels, and designed to ensure long-term economic stability. 

These rules aim to reassure investors, credit rating agencies and the public that the government is committed to sustainable finances. They help prevent excessive borrowing, reduce the risk of inflation and maintain confidence in the UK economy. 

The UK government’s fiscal principles include: 

• Funding day-to-day spending through tax revenues, not borrowing  
• Reducing public debt as a share of gross domestic product (GDP) over the medium term  
• Keeping public sector borrowing within ‘sustainable limits’  

These commitments are designed to balance economic growth with fiscal discipline. But sticking to them becomes harder during periods of economic uncertainty, or when political pressure mounts to increase public spending.  

Fiscal rules aren’t just about good governance; they’re about policy credibility and trust. Investors in government bonds (gilts) watch closely to see if the government sticks to its promises. When confidence falters there can be consequences.

Right now, the UK is under scrutiny. At the time of writing, the cost of 10-year government borrowing has risen to around 4.5%, the highest among developed economies¹. This suggests investors are demanding a premium to lend to the UK, reflecting concerns about fiscal sustainability.

If markets believe fiscal rules will be broken or watered down without a clear medium-term plan for growth, then long-term borrowing costs rise. This creates a vicious cycle. Higher borrowing costs lead to more debt, which in turn pushes costs even higher.

High levels of government debt and rising interest rate costs can, over time, constrain monetary policy. This is referred to as ‘fiscal dominance’ and creates a scenario where policy choices tilt toward maintaining financial stability and steady nominal growth, away from concerns about inflation.

Relaxing fiscal rules isn’t always negative. Governments worldwide are loosening their fiscal stance to support growth. Germany, for example, has announced a €500 billion investment package, to revitalise the nation’s infrastructure and bolster its defence², a major shift from its traditionally cautious approach.

Fiscal stimulus can boost growth and market liquidity by increasing the money supply. But it also carries risks, particularly if it fuels inflation. The bond market volatility of 2022 is still fresh on investors’ minds as this is when inflation surged and interest rates spiked.

One option is to rely on fiscal drag, the phenomenon where a government's tax revenue increases because tax thresholds are not adjusted for inflation and wage growth. While this helps raise revenue without headline tax hikes, it also squeezes household budgets and could dampen consumer spending.

During periods of elevated public debt, governments also sometimes rely on ‘financial repression’, keeping real rates modestly negative to help stabilise debt ratios over time. Unfortunately, while this tactic can be an effective tool to manage government debt levels, it has serious and predictable consequences for consumer purchasing power.

Fiscal rules are more than political talking points. They’re signals of how the government plans to manage the economy. When these signals are clear and credible, markets tend to respond positively. When they’re not, volatility can follow. Remember as always, investments carry risks and you could get back less than you invested. 

Here’s how different asset classes could be affected: 

Bonds 

• If rules are upheld: This could be positive for gilts, as credibility supports demand and keeps yields stable 
• If rules are relaxed without a credible roadmap: Longer-duration bonds could be negatively affected because they are vulnerable to rising yields. We favour shorter-duration bonds to reduce volatility and aim to provide cash-plus returns 

Equities 

• Looser fiscal policy can boost equities in the short term, especially sectors that benefit from higher nominal activity, including financials and industrials 
• Tighter fiscal policy reduces consumer spending leading to slower economic activity and lower corporate earnings. Equity markets, therefore, tend to struggle in this environment 

Alternatives 

• Infrastructure and real estate assets can be pressured by higher long-term yields due to their long payback periods. Higher yields make government and corporate bonds more competitive for income-seeking investors, while increased borrowing costs make new projects more expensive to finance 
• Select hedge fund strategies may help smooth volatility. Hedge funds are pooled investment funds that use different strategies to generate returns for investors. These often include the use of leverage (borrowing), financial instruments like derivatives and short selling. Short selling involves borrowing shares and selling them on with the expectation of buying them back at a lower price to profit from the decline in value  

Gold 

• Seen as a hedge against currency weakness, policy uncertainty and persistent inflation risk 
• Central bank demand for gold remains strong, reflecting concerns about global debt and currency debasement 

Periods of market volatility and shifting fiscal policies can feel unsettling, but history shows that disciplined strategies often deliver the best outcomes. Portfolios differ but this is what we consider for investors.

1. Stay invested 
   Market ups and downs are part of the journey. Trying to time the market often does more harm than good, as missing just a few strong days can significantly reduce long-term returns
2. Diversify across asset classes 
   A well-balanced portfolio that includes equities, bonds, and alternatives can help spread risk and smooth returns over time
3. Manage duration thoughtfully 
   Manage duration thoughtfully. Shorter duration can reduce sensitivity to rate moves and active duration management may add value if inflation proves uneven
4. Think beyond cash 
   Even at 4% interest, cash may deliver negative real returns if inflation runs higher. Outside of an emergency fund, keeping money idle risks eroding purchasing power over time. But remember, investing is riskier than cash savings and you may get back less than you invested
5. Consider inflation hedges 
   Assets like gold and other real assets can provide protection against currency debasement and inflationary pressures, but their prices can be volatile and may fall in value, so they are not risk-free

1. Evelyn Partners/LSEG
2. DW.com, Germany approves huge investments with Green Party backing, 18 March 2025

Visit our Autumn Budget hub to keep up to date with the latest Budget news and announcements or register for our webinar series to unpack the Budget day updates and future developments.