By William Schomberg and Andy Bruce
LONDON, March 3 (Reuters) - The forecasts underpinning British finance minister Rachel Reeves' budget update on Tuesday may already be in tatters, unravelled by war in the Middle East and by her own government's unpopularity.
Reeves told parliament that the country remained on track to emerge from years of low growth and high borrowing and that she had a slightly bigger margin for meeting her fiscal targets, according to the Office for Budget Responsibility watchdog.
She made around a dozen references to the uncertainty rocking geopolitics in her speech but offered no caveats when declaring that the OBR's projections showed that her plan was the right one.
"All well and good, then, aside from the significant chance that the new forecast is already out of date before the ink has dried," Andrew Wishart, senior UK economist at Berenberg, said.
Bond investors barely paid heed to Reeves. The cost of long-term British government borrowing posted one of its biggest one-day jumps in years as the U.S.-Israeli war against Iran sowed fears of higher energy prices and global inflation.
"The OBR forecasts may show debt stabilising over the decade, but that depends on a world that is already shifting," Daniele Antonucci, chief investment officer at Quintet Private Bank, said.
"Even modest moves in yields show how sensitive the public finances are to further shocks," Antonucci said, adding that his bank had recently reduced its holdings of British gilts.
For its part, the OBR, which compiled its forecasts before the turmoil in the Middle East began, warned that the conflict "could have very significant impacts on the global and UK economies."
RECOVERY AT RISK
Things had been looking rosier for Reeves until last weekend. British government borrowing costs were coming down, there were signs of a nascent recovery in the economy and figures showed a boost to the public finances in January.
But the escalating conflict in the Middle East threatens to ruin that promising outlook if the surge in oil and gas prices is sustained in the coming months.
Britain's dependence on global gas markets for electricity generation and home heating, and its limited gas storage capacity - capable of holding only around a week's supply during the peak winter period - leave it more exposed to energy price spikes than many of its European peers which have moved faster to electrify heating.
Its inflation rate is the highest among the Group of Seven economies at 3% although it is expected to slow to 2% soon.
Berenberg's Wishart said the 18% jump in oil prices and a 40% rise in natural gas prices compared with his assumptions would push inflation back close to 3% by the end of 2026.
That would erode Reeves' headroom against meeting her fiscal rules.
Capital Economics estimated her room for manoeuvre could be squeezed to about 16 billion pounds from an already slim 24 billion under the OBR's latest forecasts, if oil and gas prices do not fall from their current levels until next year.
Investors have cut their bets on the BoE lowering interest rates this year to just one quarter-point reduction compared with the OBR's assumption of around two, potentially adding to the drag to the economy.
Another risk is closer to home - Prime Minister Keir Starmer's grip on Downing Street was further weakened last week when his Labour Party lost what had been a safe parliamentary seat, and his next test will come with local elections in May.
After several policy U-turns that raised questions about his leadership, Starmer also came under fire for his 2024 decision to name Peter Mandelson as the UK's envoy in Washington despite his known connections to late sex offender Jeffrey Epstein.
A YouGov opinion poll published by Sky News on Tuesday showed Starmer's Labour in third place behind Nigel Farage's Reform UK and the Green Party.
Reeves urged Labour lawmakers to "reject the political instability which would put at risk all the progress we have made".
But analysts are assuming that Starmer, if he survives the next few weeks, would come under pressure to spend billions of pounds on helping households offset any sustained increase in their fuel bills.
ELECTION RISKS
Ruth Curtice, head of the Resolution Foundation, a think tank which focuses on living standards, said the absence of policy announcements by Reeves on Tuesday did not hide the fact that painful decisions needed to be made, potentially testing the government's fiscal resolve before a national election due in 2029.
"The government still faces the prospect of going into the next election with major tax rises and a fresh squeeze on public services funding," Curtice said.
The Institute for Fiscal Studies, another think tank, said the biggest test of Reeves' tax and spending plans was likely to come in 2027 when she is due to draw up a set of spending plans for the coming years.
On top of broad demands for higher spending on public services and a recent promise to increase investment in meeting needs for education of people with special needs, Starmer has said he wants to speed up an increase in defence spending.
"Political uncertainty clearly also adds to the risk around the borrowing numbers," the IFS said.
(Writing by William Schomberg; Editing by Hugh Lawson)
