MNI INTERVIEW:QE Legacy To Push Up UK Debt Costs As Rates Rise

The UK’s large index-linked bond portfolio and extensive gilt purchasaes by the Bank of England have left the country badly placed to inflate away government debt, with increases in the official policy rate set to push up interest costs for a long period, the Office for Budget Responsibility’s David Miles told MNI.

While the increasing cost of the index-linked debt will not be paid for years as inflation moves sharply towards 10%, it accrues now in government books, Miles, a member of the official fiscal forecaster’s steering committee, said in an interview.

“It is a very big number," he said, though he noted that the effect should fade as inflation falls back and that a rising Bank Rate is likely to have a more enduring effect on debt costs.

“In the year in which interest payments really spike up, which is this coming financial year, it is much more about the inflation uplift to index-linked debt than it is about Bank Rate,” Miles said.

Thanks to the BOE’s purchase of GBP875 billion of gilts through its quantitative easing programme, an extra percentage point rise in Bank Rate will add something above GBP8 billion to debt interest costs, depending on the exact size of reserves. For the moment, though, this is dwarfed by the rising cost of the GBP500 billion in linkers.

"The flip side of that is if our central forecast turns out to be roughly right then inflation falls back really quite quickly as we move through next year" and debt costs "will fall back with it, because the RPI uplift on index-linked gilts will fall back down as well," he said.

INFLATING AWAY DEBT DIFFICULT

But inflating away debt “is difficult and I am sure it is not part of anyone’s plan anyway. It is much less likely to happen than in the past,” Miles said.

In its projections underpinning the government’s Spring Statement mini-budget, the OBR forecast that CPI inflation would drop from 7.4% this year to 4.0% in 2023 and just 1.5% in 2024, on the market view that Bank Rate rises to 1.9% then eases.

OBR forecasts of debt interest costs were conditioned on the assumption that while the Bank would continue to shrink its gilt holdings through non-reinvestment of maturing gilt proceeds, it would not start actively selling gilts, a move which it has said it will consider when Bank Rate hits 1%.

"Our assumption is that what we get is passive reversal of QE. That is not a forecast; it is the conditioning assumption,” Miles said.

If gilts were to be sold back, the government would face the cost of restarting interest payments on the securities, whose cost to the public purse would no longer equate to Bank Rate.

"What it would mean is that the sensitivity of the effective interest costs to the government to a Bank Rate increase would be less as the stock of bonds held at the central bank falls along with the reserves created through gilt purchases. It is a bit like increasing the maturity of the outstanding stock of debt and making it more long-term fixed than highly variable and directly linked to Bank of England Bank Rate,” Miles said.