Crunch nears for UK's Reeves, with stability elusive and markets wary

(Adds "consultancy" to description of LB Macro in paragraph 17)

By Andy Bruce, Kate Holton and Elizabeth Piper

MANCHESTER, England (Reuters) -After a year in office, Britain's finance minister Rachel Reeves faces a reckoning over unmet promises of economic stability, with a stop-start economy and restive bond markets pointing to another tax-raising budget that she had hoped to avoid.

Wednesday saw the biggest collapse in British government bond prices since the ill-fated 2022 economic agenda of former prime minister Liz Truss, sparked by investor fright at a tearful appearance by Reeves in parliament.

A major rebellion in Prime Minister Keir Starmer's Labour Party against welfare reforms - which forced him to gut key parts of the plan - also fed doubts about its ability to cut spending and raised questions about party control.

Economists say events this week have increased the chance that Reeves will need to raise tens of billions of pounds in taxes later this year after the government's plan to grow the world's sixth largest economy failed to sufficiently deliver.

That would further heap pressure on a party that has consistently trailed Nigel Farage's insurgent, right-wing Reform U.K. in the polls.

Economists say the government is caught between unruly lawmakers, a disgruntled electorate and rising borrowing costs that risk getting higher still if investors think the government has lost control of the public finances.

"The economy is still stuck with sluggish growth," Michael Saunders, senior adviser to Oxford Economics and a former member of the Bank of England's Monetary Policy Committee, told Reuters.

"That means voters are persistently disappointed because they don't feel the living standards are getting any better."

While more tax hikes are likely coming, he questioned whether the government had the stomach to raise the sums needed to put the public purse back on a sustainable footing - again raising the issue of investor confidence.

ECONOMIC STABILITY

Reeves and Starmer came to power a year ago, vowing to deliver political and economic stability and sustainable growth after 14 often-chaotic years of Conservative government rule.

To win over investors, Reeves set what she described as non-negotiable fiscal rules, and angered businesses and households by raising 40 billion pounds ($55 billion) in taxes at her first budget, the biggest tax increases for three decades.

Reeves had said that would be a one-off event to fund much-needed investment in Britain's decaying infrastructure.

But economists say the limited headroom she had against that fiscal target has likely been wiped out by the reversal of cuts to the ballooning welfare budget, and a warning of a growth downgrade from the official economic forecaster - requiring higher taxes to keep the fiscal plans on track.

"That ballpark (of repeating her first budget) is very much within the realms of the possible," said Ben Zaranko, associate director of the Institute for Fiscal Studies think tank.

That prospect means investors are increasingly questioning the credibility of an approach that leaves the government scrambling to find ways to restore fiscal headroom whenever there is bad news on the economy.

And the violent market moves on Wednesday encapsulated unease over slipping budgets and the potential for more borrowing, with public sector debt currently just below 100% of GDP.

"Any tax hike needs to be big, and it needs to be clear. Then you can restore the market's confidence," said Simon Harvey, senior macroeconomist at Swiss-based hedge fund consultancy LB Macro.

"What we don't need is another round of 15 different measures where you question where the accounting is coming from."

Harvey said Britain's economy might require a painful reset before it can recover: higher taxes, an economic slowdown and then fast Bank of England rate cuts which will eventually boost growth and the public finances.

All of that will cause alarm in Starmer's Downing Street, which has been criticised for its handling of the welfare vote, and its connection with the parliamentary party group.

Some Labour lawmakers expressed frustration that his team didn't listen to their concerns on financial cuts for disabled people, and the prime minister admitted he had been distracted by international events before he focused on the welfare vote.

But lawmakers, many of whom feel greater loyalty to their voters than to the government, could now lobby for other policy changes, especially an end to a two-child cap that lets parents claim financial support only for their first two children.

Starmer has responded by listing his government's achievements to show it is making a difference, citing trade deals, inward investment and more money for schools and hospitals.

But the polls have refused to budge and some investors are joining the fray by criticising Britain's leadership.

A hedge fund manager who has supported Labour said voters and many businesses did not realise that the government had to rein in its spending, and that Starmer needed to "lead on how to get out of the predicament" because the options were likely to "feel dreadful".

($1 = 0.7322 pounds)

(Reporting by Andy Bruce in MANCHESTER, Kate Holton, Elizabeth Piper and Andrew MacAskill in LONDON; editing by Mark Heinrich)