ALEX BRUMMER: Every time the Bank of England’s Monetary Policy Committee raises interest rates, it provides a right hook for the Treasury
- Britain chose to fund about 25% of its national debt with inflation-linked bonds
- Every time the bank raises interest rates, it is a blow to public finances
- Bizarre as it is that the return on indexed stocks is determined by the retail price index
- That the government should have committed itself so closely to RPI is frankly insane
Right Hook: Every time the Bank of England raises interest rates, it takes a big blow to public finances
A legacy of the 2008-09 financial crisis and Covid-19 is that most of the world’s advanced economies are entering the era of high inflation with hefty loans and debt.
Britain seems to be in a better place at first glance. A focus on old-fashioned Tory values of fiscal responsibility by Chancellor George Osborne and his successor Phil Hammond led to prolonged pressure on household incomes, austerity and outcry from the political left.
As a result, total loans and debts are well below those of the US, Japan, Italy and France. That should mean the next Tory leader – whether the £30bn headroom has been used or not – should have more flexibility to use the national credit card than his or her counterparts.
But here is a very big asterisk for Britain’s public debt. Britain is the only one of the leading economies to choose to finance some 25 percent of its national debt by issuing inflation-linked bonds.
That means every time the Bank of England raises interest rates, and it has now done so six times in a row, culminating in a rise in the last half of a percentage point to 1.75 per cent, it is a major blow to public finances.
Equally bizarrely, the return on indexed stocks is determined by the retail price index (RPI). At 11.8 percent, the RPI is rising hotter than the internationally recognized consumer price index (CPI). The UK CPI rose to 9.4 percent in July and is expected to peak at 13.3 percent later this year.
Every time the Bank’s monetary policy rate-setting committee raises rates, it provides a right hook for the Treasury.
One of the reasons the Treasury was so excited about the 1.25 percent NHS and social care levy last year is the panic in the ranks about the impact of higher borrowing costs on the country’s coffers. The latest jump will add £5.5 billion to the UK’s £2.3 trillion interest bill.
That would be more than enough for a year’s investment in HS2 or even a national water network, if there were such a thing.
Inflation of index-linked debt means that every one percentage point increase in the RPI adds up to a precious £6.2bn.
It’s obvious why RMT leader Mick Lynch always quotes RPI when he talks about treating the railroad men fairly.
A shrewd negotiator, he uses the largest number before getting into his modest union-supplied Toyota Prius.
That the government should have committed itself so closely to RPI is frankly insane.
So how did this come about? After many years of meeting the 2 percent inflation target, there was great confidence (some might say complacency) in the Treasury and the Bank of England that issuing inflation-proof debt was safe.
It was in high demand from major gold buyers, the insurers and pension funds, and at a time of high borrowing, the possibility of a gold strike was eliminated – an unwillingness to buy.
The Office for Budget Responsibility notes that, at £493.2 billion, the UK’s share of indexed debt “remains consistently higher than in the G7”.
A look at the chart showing when most of this toxic indexed debt was issued shows that it peaked in the period immediately following the financial crisis when George Osborne was chancellor.
Notably, there was another wave in 2020-21 as the pandemic brought the UK economy to a standstill and bank governor Andrew Bailey was so confident that inflation had been lifted that he considered moving to negative interest rates.
What is now clear is that the heavy reliance on index-linked bonds is a colossal miscalculation and arguably just as costly as the Bank’s dire inflation forecasts.
Ultimately, it is the chancellor of the day that signs off and mixes government bond issuance. So Osborne and Rishi Sunak must bear the ultimate blame. But chancellors do not operate in a vacuum and receive expert advice from Debt Management and the Treasury.
It has proved deeply flawed. The same “groupthink” that failed to anticipate the inflation threat at the Bank of England seems to have advised successive chancellors through its Treasury team.
The taxpayer is now being asked to pay heavily for a series of bad, inexplicable decisions.