Quicker Rate Rise May Imperil Sunak’s Fiscal Rules, U.K. Watchdog Says

(Bloomberg) -- The U.K. Treasury will miss its fiscal rules if interest rates rise by 1 percentage point more than forecast without a surge in economic growth, the government’s fiscal watchdog said. 

The Office for Budget Responsibility expects Britain’s benchmark lending rate will reach 0.8% in 2023. OBR Chair Richard Hughes said, “Another 1% on top of that over the medium term wipes out the government headroom.”

The warning comes a week ahead of a decision by the Bank of England on whether to trigger the first rate rise since before the pandemic. Financial markets anticipate an increase on Nov. 4 followed by further increases that would push the key lending rate past 1% by the middle of next year.

Chancellor of the Exchequer Rishi Sunak’s annual budget statement yesterday included 75 billion pounds of giveaways, defying expectations for a fiscal tightening. Hughes described the measures as “stimulative” and said they’d add to inflationary pressures over the next couple of years.

The chancellor built in 20 billion pounds of headroom above his threshold for the fiscal rules to allow for economic shocks. An unexpected surge in the bank rate would wipe out that cushion, Hughes said.  

Market moves, partly offset by a better growth profile, have already reduced the fiscal space by around 3 billion pounds, he said. 

The fiscal watchdog “expected some kind of yield curve reaction” in interest rates markets in response to the stimulus when it was preparing its outlook, Hughes said. Since the forecast was closed, markets have added about a quarter of a percent to government borrowing costs. 

“We are watching how markets react and the Bank of England’s decision,” Hughes said.

Higher inflation came to the chancellor’s rescue in the budget. The OBR upgraded its estimate of the nominal size of the economy by 4.1%, or 110 billion pounds. Only 1% of that was better real-terms growth, with higher prices accounting for the rest. That in turn gave the chancellor an extra 38 billion pounds of annual spending power.

“Inflation has been particularly good news for the public finances because the chancellor froze personal allowances back in March,” Hughes said. “More people end up paying higher rates of tax as inflation drags more people into higher income tax brackets.”  

He noted that gross domestic product is recovering faster than foreseen in March partly because “we are having a more inflationary recovery than expected.”

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