A ‘triple blow’ to the Treasury: Inflation and rate hikes to fuel government lending as Bank of England forecasts recession
Red-hot inflation and rising interest rates will wreak havoc on the treasury, economists warned yesterday.
The rise in the cost of living is set to hit 13.3 percent in October, the Bank of England forecast yesterday as it forecast a recession in the UK that would drag on for more than a year.
This will drive up interest payments on the sky-high debt mountain of £2.3 trillion, a quarter of which is pegged to the RPI (retail price index) measure of inflation.
The rise in the cost of living will reach 13.3% in October, the Bank of England predicted yesterday as it forecast a recession in the UK, which would drag on for more than a year
At the same time, efforts to reduce the rising cost of living by raising interest rates will also add to the new chancellor’s woes. Combined with a shrinking economy, they will create a triple whammy for the treasury.
Bank of England officials yesterday voted to raise interest rates by 0.5 percentage points – the largest increase in 27 years – in a bid to get a handle on the cost of living crisis.
It is the sixth time the Bank has raised interest rates since December last year, from their pandemic low of 0.1 percent, as it struggles desperately with rising inflation.
But a higher base rate of 1.75 percent, the level last seen in late 2008, will drive up the cost of borrowing for the government and ordinary Britons.
Paul Dales, UK chief economist at consultancy Capital Economics, said: ‘It’s a triple blow. Due to the rise in interest rates and the higher inflation forecast, government financing costs will be higher than usual.
And then the recession means that tax revenues are lower than usual and benefits are higher, which means that the government borrows more.’
Dales already predicted that borrowing would reach £110 billion in 2022-23, compared to the official budget watchdog’s forecasts of £99 billion.
Even before yesterday’s dismal projections from the Bank, interest payments on the UK’s debt pile jumped to a record high of £19.4 billion in June.
The troubling projections for the Treasury come as hopeful Liz Truss of the Tory leadership promises tax cuts to boost growth.
While the Office for Budget Responsibility previously predicted the next chancellor would have around £30bn in ‘wiggle room’ if they still wanted to meet their goal of hitting a budget surplus by 2025-26, that will now likely be swallowed up by higher interest payments.
It means Truss will likely have to borrow more if she wants to scrap some money from families’ tax bills.
Simon French, chief economist at investment bank Panmure Gordon, said the bank’s new forecasts “would be a disaster for tax-cutting plans if Truss wants to maintain the same tax rules” as former Chancellor Rishi Sunak.
But he argued he could see a justification for borrowing more to help needy households in such exceptional circumstances, even if it would dent the state treasury.
The Bank predicts that CPI inflation – which is usually a few percentage points lower than the RPI – will reach 13.3 percent in October.
That’s much higher than the 11 percent predicted by Bank of England Governor Andrew Bailey two months ago. It would also be the highest inflation rate since September 1980.
The rise in the cost of living will remain high for most of next year, the Bank warned.
The damage this inflicts on households will reduce their spending, pushing the country into recession from the last quarter of this year.
The downturn will last until the end of 2023, the Bank predicted, in a recession similar to that of the early 1990s.
Bank ready to settle QE life support
Bank of England governor Andrew Bailey said he expected to reduce gold holdings by around £80bn over the course of the year
The Bank of England will begin actively winding down its massive money printing program that has pumped billions of pounds into the economy during Covid.
Threadneedle Street officials said they would begin selling the huge pile of government bonds they had amassed from September, subject to a final vote.
The quantitative easing (QE) program was launched during the financial crisis, but was revived during the pandemic.
It involved buying hundreds of billions of pounds of government bonds – or debt lent to the government – from investors, freeing up more money for them to spend elsewhere in the economy.
But the Bank plans to sell those gilts back and tighten monetary policy in an effort to bring inflation back from its 40-year high. Governor Andrew Bailey said he expected to reduce gold holdings by about £80 billion over the course of the year.
While this could help lower inflation, it will likely drive up the cost of borrowing – the market will be flooded with gilts, so their costs will fall, meaning the effective interest they pay out will be higher.