Rising inflation could cost the Treasury dearly

What will be the impact of rising price inflation on public borrowing?
According to a new analysis, higher prices could result in HM Treasury spending an additional £12 billion this year, constraining Chancellor Rishi Sunak to offer more giveaways in the Budget.

A significant part of these higher borrowing costs is debt linked to the Retail Price Index (RPI) measure of price inflation. Almost a quarter of the £2.2 trillion national debt is RPI-linked.

As price inflation rises, the Treasury has to pay more to RPI-link gilt investors.

Back in March, the Office for Budget Responsibility forecast RPI inflation to peak to 3.1% in the three months to June. RPI reached 3.9% last month, and many expect it to rise further during the rest of the year.

A combination of higher prices compared to the slump last year and supply chain challenges are set to push up inflation for the remainder of 2021.

One economist, commenting in The Telegraph, said he expects RPI inflation to reach 4.9% by the end of the year.

Samuel Tombs of Pantheon Macroeconomics told the newspaper:

“Our forecast for further above-trend month-to-month increases in the RPI over the next nine months implies that debt interest payments will overshoot the OBR’s March Budget full-year forecast by about £12bn.”

Each percentage point increase in price inflation would add around £6.5 billion to borrowing costs.

However, rising prices also mean the economy is growing, leading to higher tax revenues for the Treasury.

On the positive side, the Chancellor has created some headroom versus the OBR’s forecasts, with the deficit at £26 billion lower than forecast in the first third of the year. A more robust than anticipated economic recovery has resulted in this lower than expected deficit.

Another positive for the Treasury is the low cost of borrowing associated with the new green government bonds being launched next month, as investors rush to invest in ethical investments.

While the coupon for these green gilts is still to be announced, the green premium (or ‘greenium’) associated with ethical investments will likely mean a meagre cost of borrowing for the government.

A Treasury spokesman said:

“The independent Monetary Policy Committee of the Bank of England has responsibility for controlling inflation, and have kept CPI inflation around the 2pc target on average.

“We closely monitor inflation and, in the March Budget, have set out the actions we are taking to ensure the public finances return to a sustainable footing.”