Amid fears of being outflanked by the Scottish National Party (SNP), the Shadow Cabinet has agreed a U-turn on George Osborne's 'Charter for Budget Responsibility' that commits parties to running a budget surplus.
MPs are due this Wednesday to vote on Mr Osborne's plan to wipe out the deficit by 2019-20 and legally commit the Government to running an overall surplus in "normal times".
Although he had pledged his support for the Osborne plan just two weeks ago, Mr McDonnell told Labour MPs that he had detected a 'shift change' in attitudes in the party to toughen its opposition.
The U-turn - unveiled at a fractious meeting of the Parliamentary Labour Party on Monday night - prompted claims from some Labour MPs that the party had walked right into Mr Osborne's trap of painting the Opposition as untrustworthy on Britain's finances.
It was swiftly seized upon by the Chancellor, who claimed "Labour's economic policy has lurched from chaos to incredibility".
The change of heart follows intense lobbying from the Left of the party, underscored by a HuffPost UK blog by Labour MP and Treasury Select Committee member Helen Goodman, in which she had threatened to vote against her leader to oppose the Osborne plan.
Mr McDonnell told MPs that he had 'spoken to as many people as I can' in recent days, before changing policy. A party spokesman said that there had been a 'discussion on the phone' with the Shadow Cabinet.
He also stressed that the move was part of a bid to shore up Labour's support in Scotland, adding "I think our tone has to change and our attitude has to change" to combat the SNP.
The Shadow Chancellor added that he knew the danger of Labour being seen as 'deficit deniers' and revealed he would publish on Wednesday a full statement setting out how Labour was a party of 'fiscal responsibility'.
In a statement, he said: "As the nature and scale of the cuts Osborne is planning are emerging there is a growing reaction not just in our communities but even within the Conservative Party.
"The divisions over the cuts in tax credits to working families are just the first example of what we can expect as the cuts in other departments are exposed and the failure to find additional resources to bridge the growing expenditure gap in service areas like the NHS is revealed.
“We will underline our position as an anti-austerity party by voting against the charter on Wednesday. And Labour will set out our plan for tackling the deficit not through punishing the most vulnerable and decimating our public services but by ending the unfair tax cuts to the wealthy, tackling tax evasion and investing for growth.”
In a bid to explain his U-turn, Mr McDonnell said in a letter to MPs that a series of economic reports in the last fortnight had laid bare "the economic challenges facing the global economy as a result of the slowdown in emerging markets”. He also told MPs that global recession and inflation were a threat again.
But Mr Osborne hit back: "Two weeks ago they said they were going to vote for a surplus - now we know they want to keep on borrowing forever. That would be a grave threat to the economic security of working people."
Only last month at the Labour party conference, Mr McDonnell surprised his critics by saying he would sign up to the Osborne plans.
Mr McDonnell told the Guardian last month: "We will support the charter. We will support the charter on the basis we are going to want to balance the books, we do want to live within our means and we will tackle the deficit."
The heated meeting saw Labour backbencher John Mann lambast the Corbyn-McDonnell leadership for "shambolic politics" which lacked "any aspect of democratic politics" after their failure to consult widely among MPs.
Mr Mann added the U-turn was 'a huge joke', while former Cabinet Minister Ben Bradshaw left the meeting describing the change as 'a total f*cking shambles'.
Some Labour MPs told HuffPost UK they planned now to abstain from the vote, as well as the Immigration Bill second reading, in a bid to avoid falling into the 'Tory trap' to portray Labour as soft on the deficit and immigration.
The meeting was also marred by Labour MPs complaining that a new leftwing group 'The Momentum' was a 'party within a party', and its backer Richard Burgon was jeered by colleagues for claiming it was no different from Progress or the Fabians.
Writing on The Huffington Post UK today, Helen Goodman, a member of the Commons Treasury committee, attacked the plan.
"The truth is this measure has nothing to do with improving our economic performance it is an excuse to ease the political programme of shrinking the state," she said.
Goodman said: "As a member of the Treasury Select Committee I quizzed a range of economists on this idea. Not one, not even the Governor of the Bank of England would endorse it.
"In June, 79 economists (mainly from the Left and including several on John McDonnell's Council of Economic Advisers) published a letter saying these proposals 'have no basis in economics... risk a liquidity crisis that could bring banking problems, a fall in GDP, a crash or all three'.
"They pointed out that a permanent government surplus would raise indebtedness in the household and business sector. Personal indebtedness is already running at 145% of disposable household income, a total of £1.7trillion and there is a case for pulling this back. It is £200billion above government debt already.
"The economists also said that this would prevent the government from responding to the changing economic conditions to stabilise the economy. In other words, this is a proposal to return to pre-Keynesian economics."
The SNP, which opposes the charter, was all set to seize on Corbyn's decision to support Osborne's charter as evidence of Labour's failure to challenge austerity.
SNP deputy leader Stewart Hosie had previously accused Labour of failing to protect Scots from austerity. Tonight he tweeted about the chaos of the party's change of heart.