U.K. Inflation Pushes Up Treasury Debt Payments to a Record

Inflation took a toll on the U.K. public finances last month, driving interest payments on government debt to unprecedented levels.

The Treasury paid 8.7 billion pounds ($11.8 billion) in interest in June, the most for any month since records began in 1997, the Office for National Statistics said on Wednesday. The 6 billion-pound increase from a year ago was due to higher retail-price inflation pushing up the cost of servicing index-linked gilts.

The figures indicate the constraints on Chancellor of the Exchequer Rishi Sunak, who pushed government borrowing to a peacetime record to protect workers out of a job during the pandemic. While the overall deficit is coming in lower than the Office for Budget Responsibility estimated in March, rising debt costs threaten to absorb any windfall.

“The spike in debt interest payments won’t derail the deficit reduction, but risks remain,” says Michal Stelmach, senior economist at KPMG U.K. “We are not out of the woods yet with the recent surge in Covid-19 cases putting some parts of the economy at risk of further restrictions later in the year and the uncertainty around the impact of phasing out the furlough scheme on unemployment.”

U.K. Inflation Pushes Up Treasury Debt Payments to a Record

The retail price index surged to 3.9% in June from a year ago in June, up from as little as 0.5% in the summer of last year when the economy was starting to open up from the first coronavirus lockdown. While the Bank of England targets the consumer price index, which has showed a slightly less acute increase, government debt along with student loans and rail fares track the RPI.

A quarter of the government’s debt, about 448 billion pounds, is linked to inflation indexes, the Debt Management Office says. The OBR estimates that if inflation hits 5%, interest costs would increase by up to 9 billion pounds because of index-linked gilts.

OBR Chair Richard Hughes said the Treasury should reconsider the portion gilts it sells that are index-linked, noting that inflation remains a risk to the public finances.

“You need to go in there with your eyes open and understand what risks are developing,” Hughes said at a hearing of lawmakers on the Treasury Committee in Parliament on Wednesday “In particular if you see rising inflation in the context of stagnant growth that’s potentially a big risk.”

Read more: U.K. OBR’s Hughes Says Inflation Is A Risk to Treasury Finances

Inflation is “no longer a very effective way to reduce the debt-to-GDP ratio,” the OBR said in a report earlier this month outlining risks to the public finances. It noted the U.K. has a “relatively high” proportion of index-linked debt as well as shorter maturities that are a “by-product” of the BOE’s bond-buying program to stimulate the economy.

The overall deficit came in lower than officials forecast in the first three months of the fiscal year as an unexpectedly strong economic rebound absorbed workers who were receiving benefits.

“I’m proud of the unprecedented package of support we put in place to protect jobs and help thousands of businesses survive the pandemic, and that we are continuing to support those who need it,” Sunak said in a statement. “It’s also right that we ensure debt remains under control in the medium term, and that’s why I made some tough choices at the last budget to put the public finances on a sustainable path.”

The strength of the economic rebound from the deepest slump in 300 years has taken most forecasters by surprise. BOE Deputy Governor Dave Ramsden predicting the economy could even return to its pre-Covid size as early as the current quarter. For the public finances, the pickup is translating into more tax revenue from newly employed workers and less spending on pandemic support such as furlough payments.

The deficit totaled 69.5 billion pounds between April and June. That’s well below the 92.7 billion pounds forecast by the OBR at the time of the budget in March. Tax revenue surged by 18% in June from year ago, while spending climbed 3.1%.

U.K. Inflation Pushes Up Treasury Debt Payments to a Record

While those figures are a comfort to Sunak, a surge in the cost of government debt gives him little wiggle room to increase spending.

The Institute for Fiscal Studies estimates the Treasury’s borrowing could come in 30 billion pounds lower in the current fiscal year than the 234 billion pounds forecast in the budget in March. That windfall won’t persist because of permanent damage done to the economy by the pandemic and rising debt interest costs. It also estimates that health, education and transport need at least 10 billion pounds extra in each of the next three years.

“Borrowing remains very high, and the extent to which lower borrowing this year will translate into lower borrowing further forwards is highly uncertain,” said Isabel Stockton, research economist at the IFS.

Sunak is hoping to eliminate borrowing for day-to-day spending by the middle of the decade, with a combination of economic growth, tax rises on companies and departmental budget cuts.

Some of the undershoot relative to the OBR forecast is due to the ONS not incorporating the cost of Britain’s Brexit divorce bill. June saw the first of the costs -- 800 million pounds -- accrued to the public finances. The ONS said it expects similar payments in the coming months.

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