MNI INTERVIEW: UK Debt Costs To Stay Low-Resolution Foundation

Structural factors, including an ageing population and the Bank of England's monetary policy response to tighter financial conditions, should cap any rise in yields and keep the increase in UK debt interest costs manageable, James Smith, Research Director at the Resolution Foundation, told MNI.

While the UK is vulnerable to rising debt interest costs, strong forces should contain them, Smith said in an interview ahead of Wednesday's Budget, in which Chancellor of the Exchequer Rishi Sunak, reportedly worried by the fiscal risks from higher interest rates, looks set to unveil an offsetting mix of extensions of Covid income support schemes and tax rises.

Yields have recently jumped 50 basis points or more in some advanced economies and Smith recognised that the impact on UK debt payments of higher rates and higher inflation could be large. It has, by international standards, an exceptionally high proportion of inflation-linked sovereign debt and has shortened average debt maturity through quantitative easing and issuance policy.

"We have this ready reckoner that 100 basis points on yields would cost GBP25 billion … That would be a considerable tightening. If you think about that as being a number that would be on the deficit in five years' time that would be another percent of GDP of future consolidation. So that is big," Smith said.

The cost, however, looks unlikely to keep escalating. The BOE is likely to tread very carefully over tightening policy if it pushes up interest rates for households and firms, and forces that drove down rates to historically low levels in the pre-pandemic era still prevail.

"We think that there are limits to how much rates would rise given both those structural factors and the response of the Bank of England. Those are the two forces going in the other direction," Smith said.

BOE WARY OF DERAILING RECOVERY

The BOE is looking at changing its policy of only starting to unwind QE after Bank Rate rises from its current level of 0.1% to around 1.5%. But Smith, a former senior BOE economist, stresses that the Bank will again be wary of doing anything to derail the recovery.

"If they did chose to make their first instrument of tightening QE rather than Bank Rate I think they obviously would be extremely cautious and try and make that very predictable in terms of how they did it," he said.

The Resolution Foundation has advocated a sizeable increase in fiscal stimulus in the Budget with unemployment set to rise and the output gap, the shortfall of economic activity to potential, large.

Sunak, however, appears to be keen to at least take the first steps on the path to deficit reduction.

"To be in a position where the economy is roughly 10% or so below its pre-pandemic peak and unemployment is about to rise by 800,000 … then it would be odd to respond to that with tighter fiscal policy and definitely creates a risk with the speed of the recovery," Smith said.

Press reports have centred on corporate tax rises alongside extensions of Covid support schemes.

At a time when demand will be weak from the rise in unemployment, despite the boost from the relaxing of social distancing measures, "to try and prioritise raising revenue and tax takes a risk with the recovery," Smith said.