Soaring Covid Costs And The Impact On Interest Rates & Inflation

Soaring Covid Costs And The Impact On Interest Rates & Inflation

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Rishi Sunak’s has been warned by the fiscal watchdog that soaring COVID costs threatened to make Britain’s debts unsustainable if interest rates rise to curb inflation. 

In an assessment of the triple threat facing the chancellor as he battles to steady the public finances, the office for budget responsibility said that borrowing costs could surge if inflation leads to persistently higher price prices which could force the Bank of England to act. Alternatively, though less likely international investors could suddenly to lose face faith in the UK thereby forcing up interest ratees to defend the ability of the government to borrow money from international investors which will be necessary to finance the government’s budget deficit.

Carbon Net Zero Agenda

In addition, the governments carbon net zero agenda will also push up borrowing by an estimated £469 billion, probably a significant understatement, over the next 30 years. Ministers will also spend another 10 billion a year dealing with fallout from lockdown as they seek to help children catch up on lost learning and clear the backlog of 5-15 million, nobody quite knows how many, untreated hospital patients.

The Spending Watchdog

The Spending Watchdog warning threatens to heighten the tensions between Number 10 and Number 11, who is already said to be resisting Boris Johnson spending plans. Britain has racked up a record peacetime deficit in the fight against COVID, but the cost of servicing the country’s debt mountain has fallen to a record low of 0.9% of GDP because of ultra- low interest rates. 

However, inflation is starting to rise as the global recovery takes off and if this continues central banks may be forced to draw the sting by increasing interest rates. This in turn would increase the cost of state borrowing, not only for the UK but also for the US and countries in the EU. The later are more indebted, have weaker economies and are constrained in their policy options. 

This constraint is due to membership of the Euro and the one size fits all policy pursued by the European Central Bank. This policy may fit Germany and possibly France and Benelux but does not fit the rest of the EU. The tension this creates as well as others challenges the EU face will constrain the policy options which can be implemented. The consequence for interest rates, debt financing, economic growth and tax revenues will probably limit the appetite for interest rate rises. However, the political consequences may not sustain the current trajectory centralising policies of the EU elite.

Interest Rate Rise

Any significant rate rise could also cause serious damage to the wider economy by triggering a drop in house prices, by leaving borrowers unable to pay their mortgages following a scramble to buy in a red hot market. The OBR painted a scenario where the Bank of England is forced to act in response to persistent inflation of 4% over 3 years and the UK is charged more to borrow in debt markets due to fears over inflation running out of control.

It is said that a higher inflation scenario could eventually push debt servicing costs up from 1% to 4% of GDP by 2050 around £80 billion in today’s terms a level not seen since the aftermath of the Second World War in 1948.

There will be significant consequences for government spending plans were rates to return to levels that were more normal in the past, it would raise the cost of servicing a given stock of debt and could in extreme circumstances push the debt to GDP ratio in onto an unsustainable path. The clashes between the governor of the Bank of England Andrew Bailey who insists inflation risks will be transitory and its outgoing chief economist Andy Haldane who has pressed for the bank act now to counter the threat earlier than otherwise planned.

The possibility of the lingering inflation scenario pushes the UK’s debt to a share of its GDP to 107% by 2050 or 10% points or £200 billion above the watchdog’s central forecast. There has been warning that the unfunded COVID-19 legacy spending of £10 billion a year on health education and transport also presents a material risk to the public finances. Current plans also take no account of pandemic spending beyond the end of this financial year, while department spending has been cut by 14.5 billion a year from 2223 relative to pre virus plans. This is probably not going to be sustainable given the spending pressures in the public sector and will therefore be reversed which a consequent impact on borrowing and debt servicing costs.

The forecast of an extra £7 billion a year in health spending alone to deal with catching up on late treatments and revaccinations as well as billions more on education and transport to make up for lost revenues. Ministers will be forced to choose between squeezing budgets or raising taxes or borrowing to increase spending. This  puts the government’s aim of balancing current spending by the middle of the decade at risk. Richard Hughes the chairman of the office of budget responsibility (OBR) said going into the next spending round this autumn that these various pressures look at best particularly challenging if not completely unachievable.

The Chancellor said that it is important to return our public finances to a more sustainable path over the medium term, which is why we made difficult choices in the last budget and why this government is committed to fiscal responsibilities. The cost of hitting the net zero target of £469 billion over the next 30 years which will increase the debt by 21% as fuel duties revenues fall drastically and the government funds more than 25% of the estimated £1.4 trillion in investment needed to achieve net zero. It stressed that the impact on the UK’s debt mountain of the costs of going green was less than the £520 billion or 23% of GDP added to the debt total because of the COVID-19 crisis.


Meanwhile schools may need an extra £1.25 billion a year for catch up in learning. There could also be a lingering £2 billion hole in ticket revenues for Great British railways and Transport for London as business moves towards remote area models.

The Triple lock on pensions increases annually by the highest of average earnings, inflation or 2.5%. Average earnings will be artificially boosted this year by the effect of the furlough last year. The OBR says that it could cost £3 billion a year extra relative to its March forecasts because of the way the triple lock operates the more volatility there is in the macro economy the more expensive it is like to be says Hughes.

The watchdog admits that the scale of any subsidy is unknowable but assumes that the government picks up the entire cost of greening the poorest 15% of households while the middle 70% pay half and the rich is 15% foot the entire bill. In some sectors of the economy decarbonization pays for itself as improvements in battery technology drive the lifetime costs of electric vehicles below that of petrol cars but in other areas such as the replacement of household gas boilers with zero carbon alternatives come with significant net costs which society will need to bear. Acting late on climate change or ignoring it altogether makes the fiscal news even worse, however.

By the end of the century the OBR estimates debt would almost triple to 289% of GDP if the government did nothing which is partly driven by society trends such as an ageing population and higher savings but as the OBR has pointed out previously the higher stock of debt makes the UK vulnerable for a sudden rise in interest rates. Almost 30% of the UK’s debt is now held by overseas investors, compared with just 10% in the 1980s, making the nation more vulnerable to a sudden change in sentiment.

Quantitative Easing

Meanwhile the Bank of England’s quantitative easing operations which was ramped up by £450 billion following COVID-19, effectively swapped long dated debt for reserves funded at the overnight rate of 0.1% which means that the government is more vulnerable to a sharp rise in interest rates.

In the admittedly unlikely scenario for total loss of confidence in UK gilts, the OBR models which are based on the assumption of a Bank of England rate hike to 4%, with borrowing costs consequently reaching 15% of GDP by the end of the decade and an average gilt rate of 10%, which was last seen in 1991. Meanwhile the nation’s interest bill would reach 9.5% of GDP, which is high above any previous levels seen in war or peace.

Hughes added shorter debt maturities rendered the public finances more vulnerable to extreme scenarios such as the loss of investor confidence in which rising interest rates and debt feed each other in a self-reinforcing spiral, causing debt servicing costs rising prohibitively.

Certainly, food for thought for the chancellor with a wary hand on the nation’s purse strings and ambitions to move into Number 10 Downing Street.

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