Rachel Reeves should cut benefits to regain credibility with bond investors, the Institute for Fiscal Studies (IFS) has said.

Markets see “spending reform as a critical signal of intent” and tackling welfare spending is seen as the “bellwether” of the Government’s resolve to repair public finances, the think tank said in a pre-Budget report.

Moyeen Islam, a fixed-income strategist at Barclays who wrote the section of the report for the IFS, said: “Welfare is totemic for the market because it shows a willingness to do hard things.”

The remarks come after the Government’s attempts to prune welfare spending led to a series of humiliating reversals over summer, which the IFS estimated had blown a £6bn hole in Ms Reeves’s plans.

Referring to the cost of Labour’s about-turns on winter fuel payments and disability benefit cuts, Mr Islam said: “In the great scheme of a £2.5tn economy, £6bn is not a lot of money. But what £6bn can gain you is an appreciation from the market that you’re willing to take hard decisions. That, to me, is credibility bolstering or enhancing.”

The Government’s welfare policy reversals were “a red flag” for the bond market, he added. Yields on 30-year gilts, as UK government bonds are known, recently hit a 27-year high of 5.7pc, while borrowing costs for 10-year gilts are at levels last seen during the financial crisis, at around 4.6pc.

Tellingly, yields retreated to a two-month low on Wednesday after Ms Reeves said she was looking at both tax rises and spending cuts in the upcoming Budget.

In total, the IFS said Ms Reeves must enact tax rises or spending cuts of £22bn to repair the public finances at the autumn Budget.

Mr Islam said that it was crucial to restore credibility “in the eyes of an increasingly sceptical bond market” to escape being “trapped in a negative spiral” and experiencing a “mini crisis of confidence”.

He said in the report: “The market’s patience can only be tested so many times before fiscal scepticism morphs into the preconditions needed to see a full gilt funding crisis.”

Any attempt to tinker with the fiscal rules or the “architecture” of the system could also spell disaster. He warned: “In the extreme, such changes run the risk of catalysing a gilt crisis.”

The state on course to spend £373bn a year on benefits by the end of the decade, with around half of that spent on pensioners.

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Spending on sickness and disability benefits is on course to surpass £100bn without reforms.

Helen Miller, the IFS director, acknowledged that spending cuts alone would be “political difficulty”. She said: “They tried the disability benefit reforms and didn’t get them through. Labour backbenchers will now be on high alert for anything that looks like just cutting and not reform. And it absolutely needs reform.”

If spending cuts are unachievable, Mr Islam said raising income tax would also soothe jittery bond investors. This too would prove politically challenging, because Labour promised in its manifesto not to increase the headline rate.

However, breaking this pledge would “demonstrate a willingness to spend significant political capital to support fiscal stability,” Mr Islam said. “Again, the signal is crucial.“

The National Institute of Economic and Social Research, the Institute for Government and the Institute of Directors have all urged the Government to raise income tax, arguing it is the least economically damaging way to fix public finances.

Maintaining credibility with the bond market is vitally important for Labour. The UK is reliant on private bond investors to help finance spending and is on track to borrow £137.3bn this year.

A lack of faith in fiscal plans will prompt lenders to demand higher interest rates, which can have significant implications for the country.

The Government is already expected to spend £111bn on debt interest this year – more than the core schools budget. Public debt stands at nearly £3tn.

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In an extreme scenario, the IMF has suggested investors could shun countries that lack a credible plan for getting their debts under control.

Ms Miller said the Government could also improve its standing with investors by setting out long-term reforms without upfront cuts, highlighting the pensions triple lock or motoring taxes as areas that could be targetted.

The think tank also urged Ms Reeves to leave herself a bigger fiscal buffer than the £9.9bn currently maintained. The IFS said past experience suggests she will need nearly £50bn a year spare to avoid rewriting her plans.

Sir Mel Stride, the shadow chancellor, said: “Britain faces serious economic challenges, but instead of confronting them, Rachel Reeves and Keir Starmer are hemmed in by their own MPs and too weak to take the tough decisions the country needs.”

A Treasury spokesman said: “We won’t comment on speculation. The Chancellor’s non-negotiable fiscal rules provide the stability needed to help to keep interest rates low while also prioritising investment to support long-term growth.”

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