Rishi Sunak has fought to protect the Treasury from rising prices while allowing inflation to ravage the finances of low- and middle-income households. That is the accusation leveled against the chancellor after a budget statement in the spring that put the government’s debt reduction ahead of demands for additional social assistance for disadvantaged families.
With inflation heading for 8% and possibly beyond, Sunak faces a dilemma over whether he can afford to increase Treasury spending on welfare and public services, including public sector salaries.
His team believes the Treasury Department needs to keep a large fund in reserve to pay for higher debt costs, much of which are related to inflation.
Some of Britain’s debt is held by lenders in the form of index-linked bonds. The more inflation rises, the higher the interest that the state has to pay.
Then there are the £875bn of government bonds held by the Bank of England – more than a third of the total – which were yielding just 0.1% interest until last year.
Central bank officials are trying to limit the rise in inflation by raising the cost of borrowing. Two rate hikes later, and the annual interest rate is 0.75%, further increasing Sunak’s debt burden.
Public finance figures for February show that inflation has cut interest payments on government debt by more than 50% to $8.2 billion.
Nonetheless, the cost of debt relative to the government budget remains at historic lows, providing a better measure of its solvency. In the 1980s, debt interest cost the state about 10% of annual revenue. Today that figure is less than 3%, despite a mountain of debt that has more than doubled as a percentage of national income over that period.
Additionally, UK government bonds remain in high demand among international investors, meaning they are willing to accept low yields for long periods of time. And there is little prospect that recent increases in inflation will be sustained over the longer time horizons used by the Treasury Department to assess the country’s financial stability.
Inflation will fall this year and next because fuel prices are the biggest driver of rising prices. Inflation is also friendlier for the Chancellor than for companies or households. It increases its VAT revenue. There’s also a spurt of wage increases that are slightly larger than forecast a year ago, leading to more income taxes. Adding an estimated £21billion to its stash is a freeze on income tax thresholds, which are set to run for four years.
In the meantime, rising petrol prices and the higher cost of petrol and diesel will eat away at corporate and household incomes, with only limited offsetting by higher incomes or government support.
In truth, much of the Treasury’s reserve fund is being set aside to fund tax cuts ahead of the next election, when much of it could be used to keep more than 1.3 million people – including half a million children – out of poverty to be crowded line next year.