ALEX BRUMMER: Interest rate hikes are a right hook to the exchequer

A legacy of the financial crisis of 2008-09 and Covid-19 is that most of the world’s advanced economies enter the era of great inflation with chunky borrowing and debt. 

Britain on the surface looks to be in a better place. A focus on old-fashioned Tory values of fiscal responsibility by Chancellor George Osborne and his successor Phil Hammond led to a lengthy squeeze on household incomes, austerity and squeals of indignation from the political Left. 

The result is that overall borrowing and debt totals are way below those of the US, Japan, Italy and France. That should mean the next Tory leader – whether the £30bn of headroom has been used or not – ought to have more flexibility to swipe the national credit card than his or her counterparts. 

But here is a very big asterisk against Britain’s national debt. Alone among the leading economies Britain chose to finance some 25 per cent of its national debt by issuing inflation-linked bonds. 

That means that every time the Bank of England raises interest rates, and it has now done that six times in a row, culminating in the latest half of a percentage point rise to 1.75 per cent, it delivers a body blow to the public finances. 

As bizarre, is that returns on index-linked stock are set by the retail price index (RPI). At 11.8 per cent the RPI is running hotter than the internationally recognised consumer prices index (CPI). Britain’s CPI rose to 9.4 per cent in July and is predicted by the Bank of England to peak at 13.3 per cent later this year. 

Each time the Bank’s interest rate-setting Monetary Policy Committee raises rates it delivers a right hook to the Exchequer. 

Among the reasons why the Treasury was so keen on the 1.25 per cent NHS and social care levy last year is because of panic in the ranks about the impact of higher borrowing costs on the nation’s coffers. The latest jump will add £5.5billion to the interest rate bill on the UK’s £2.3trillion national debt.

That would comfortably pay for a year of investment in HS2 or even a national water grid, if there were such a thing. 

The inflation ratchet on index-linked debt means that each one percentage point rise in RPI comes in at a costly £6.2billion. 

It is clear why RMT leader Mick Lynch always quotes RPI when sounding off about treating the railwaymen fairly. 

As a smart negotiator he uses the biggest number before he hops into his modest union-supplied Toyota Prius. 

That the Government should have bound itself so closely to RPI, frankly, is bonkers.

So how did this come about? After many years of hitting the inflation target of 2 per cent there was a high confidence (some might say complacency) in the Treasury and at the Bank of England that issuing inflation-proofed debt was without danger. 

It was much in demand from big gilt buyers, the insurers and pension funds, and at a time of elevated borrowing removed the possibility of a gilts strike – an unwillingness to buy. 

The Office for Budget Responsibility observes that, at £493.2billion, the UK’s proportion of index-linked debt remains ‘consistently higher than across the G7’. 

A glance at the chart showing when most of this toxic index-linked debt was issued shows it peaking in the period immediately after the financial crisis when George Osborne was chancellor. 

Remarkably, there was another flurry in 2020-21 when the pandemic brought the UK economy to a halt and Bank Governor Andrew Bailey was so confident inflation had been slain that he contemplated moving to negative interest rates. 

What is now obvious is that the heavy dependence on index-linked bonds is a colossal misjudgement and arguably as costly as the Bank’s terrible inflation forecasting record. 

In the end it is the chancellor of the day who signs off on the Government bond issue and mix. So Osborne and Rishi Sunak must bear ultimate culpability. But chancellors don’t operate in a vacuum, and receive expert advice from the Debt Management Office and the Treasury. 

It has proved deeply flawed. The same ‘groupthink’ that failed to anticipate the inflation threat at the Bank of England looks to have infused advice given to successive chancellors by his Treasury team. 

The taxpayer is now being asked to pay heavily for a series of bad, unexplained decisions.