Spectre of rising interest rates helps Sunak’s case for tighter spending review

Rishi Sunak, UK chancellor, believes the spectre of rising interest rates has reinforced the case for holding down public spending, as he enters the final haggle over three-year budgets with Whitehall departments.

Andrew Bailey, Bank of England governor, on Sunday warned interest rate rises are on the way, which is seen by Sunak’s allies as vindication of the chancellor’s fears about the fragility of the public finances.

“It’s a concern,” said one Sunak ally, speaking ahead of next week’s Budget and spending review. “His concerns are being realised.” The chancellor has said that a one percentage point rise in interest rates and inflation could cost the Treasury about £25bn a year.

Ministers including Dominic Raab, justice secretary, Kwasi Kwarteng, business secretary, Liz Truss, foreign secretary, and Grant Shapps, transport secretary, are among those digging in for more cash.

The chancellor’s allies insisted he will this week stick to the tight public spending “envelope” set out in the March Budget and later confirmed by Prime Minister Boris Johnson. “The pie is there — it’s just a case of how you cut it up.”

Earlier this year, Sunak spoke of his concern about rising inflation, when he told the FT: “There are some people who think you can ignore the problem. Worse, there are some people who think there isn’t a problem at all.”

It was not clear who Sunak had in mind, but Johnson said this month that people had been warning about higher inflation for some time and that this had turned out to be “unfounded”.

Line chart of GDP index, 2019=100 showing The latest vintage of GDP shows a stronger recovery than the vintage to be used in the Budget forecasts

Bailey on Sunday said the BoE “will have to act” to curb inflationary pressure, making no attempt to contradict financial market moves that have priced in the first interest rate increase before the end of the year.

As the chancellor wrestles with departments that have not agreed their spending totals ahead of the October 27 Budget, a standard Treasury tactic is to paint a grim picture of economic prospects and the public finances.

Among the ministers still holding out for more money is Raab, the new justice secretary and deputy prime minister, who wants funding to clear a long-running backlog in the court and prison systems, as well as victim support services.

Whitehall officials said the minister’s predecessor, Robert Buckland, had wanted an increase of about one-third in the justice budget over the next three years, to help offset years of department cuts.

Kwarteng, who has secured almost £4bn from the Treasury to help cut home heating emissions, is fighting to maintain public R&D spending, which was supposed to hit £22bn by the end of the parliament.

Last week, Johnson sided with the business secretary in seeking “mitigations” for steelmakers and other energy-intensive industries struggling with spiralling gas prices, but Sunak has failed to sign off a package.

The chancellor on Monday told business leaders he was frustrated with requests for bailouts from companies that should be able to look after their own interests, said one person briefed on the meeting.

Meanwhile, Shapps, whose transport department received billions of Covid-related support in rail subsidies, is holding out for more money to develop infrastructure for electric vehicles, government officials said.

Truss, the new foreign secretary, wants more money to focus on the economic and security aspects of her department, although talks with the Treasury are said to be cordial.

This year, Sunak told the Office for Budget Responsibility to close its forecast earlier than normal, so that it did not include upgrades to the level of output and growth that form part of the annual revisions to the national accounts.

Since this was revealed by the Financial Times, the Treasury has stressed the rise in inflation, and likely higher interest rates, would have raised the cost of servicing debt in the Budget forecasts, which, officials said, would have made the later forecasts look worse.

Line chart of Annual change in prices (%) showing UK inflation has risen sharply this year and exceeded forecasts

The Resolution Foundation think-tank said the real picture for the Budget forecasts was the “biggest ever current-year economic growth upgrade” alongside “rising inflation [that] will squeeze both the chancellor’s borrowing windfall and family budgets this autumn”.

Sunak’s claim that a one percentage point rise in interest and inflation rates would cost the exchequer £25bn comes from the OBR, but requires some specific assumptions for the number to be that high.

Other influential figures think the chancellor is protesting too much in worrying about inflation and interest rates.

Speaking to the FT, though not specifically about the UK, Vitor Gaspar, head of fiscal policy at the IMF, said that when inflation and interest rates rise, this often comes with a strong economy and tax revenue increases too, so the rise in debt servicing costs should not be viewed in isolation.

The Treasury said: “Changes to interest rates and inflation are among many risks to the public finances that we monitor closely. That’s why we are taking action to ensure the public finances remain on a sustainable footing while we continue to support businesses, jobs and public services.”


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