The Treasury’s tax and spending watchdog is preparing to sound the alarm over the impact of rising interest rates on the public finances, delivering a serious blow to the government’s scope for pre-election tax cuts.
The independent Office for Budget Responsibility will warn that stubbornly high inflation and soaring borrowing costs are adding to the challenges facing Rishi Sunak, making it less likely that he will meet one of his five key pledges – tackling Britain’s public debt.
It is understood the OBR will produce a range of scenarios in its annual “fiscal risks and sustainability report” on Thursday, setting out the impact of higher interest rates for the public purse, in a warning that sustained pressure could force it to tear up its official forecasts.
At the start of the year Sunak centred three of his five priorities on the economy: halving inflation, growing the economy and getting debt falling.
However, leading economists warned that failure on his top priority to reduce inflation was placing all three in danger, as the Bank of England’s rapid rate rises increase the prospect of a recession, and as higher inflation and borrowing costs add billions of pounds to the government’s debt interest bill.
The UK government’s cost of borrowing on the international debt market has risen to the highest level since the 2008 financial crisis in recent weeks – surpassing the level during the turmoil of Liz Truss’ premiership.
Charlie Bean, a former deputy governor at the Bank of England and a former OBR board member, said: “Higher rates, and higher inflation which impacts payments on index-linked gilts, will clearly have considerably reduced the available fiscal space.”
With the public finances under growing strain, the chancellor, Jeremy Hunt, warned over the weekend that big pre-election tax cuts were unlikely as the government aimed to get inflation under control. Labour is also increasingly resigned to matching the Tories’ tax and spending plans for its first years in power should it win the next election.
However it warned a one percentage point rise in interest rates would add about £20bn to borrowing in 2027-28, the key year for meeting this target, more than wiping out the chancellor’s headroom.
It based its forecast on the Bank’s base rate peaking at 4.3%, and had closed its forecasting round when the yield – or interest rate – on 10-year UK government debt was 3.3%.
Since then the Bank has increased rates to 5%, with financial markets anticipating further increases to a peak of 6.3% early next year. The yield on 10-year UK gilts has risen to 4.6%.
Using the OBR’s own “ready reckoner” estimates for the impact of higher rates, analysts at Deutsche Bank said the hit to the public purse would be about £15bn a year. Bank of America said the figure could be as high as £30bn.
Carl Emmerson, the deputy director of the Institute for Fiscal Studies, said a “simple rule of thumb” was that a one percentage point rise on all interest rates would add about £15bn to the government’s annual debt interest bill, with most of the impact coming immediately.
“The chancellor didn’t really have any meaningful wriggle room against having debt falling in five years’ time in the March budget, and the fiscal outlook appears to have deteriorated since then as interest rates have risen,” he said.
“And it is not clear that the prospects for tax revenues, for example due to an improved outlook for growth, have improved.”
The prospects for the public finances are complicated by uncertainty over future economic growth, while the exchequer also stands to benefit from stubborn inflation dragging more workers into paying higher rates of tax.
The government could also take evasive action to meet its debt-cutting targets – including a renewed round of austerity spending cuts or tax rises – or could scrap the self-imposed rule.
Robert Wood, the chief UK economist at Bank of America, said: “The question is not whether it is broken, but what action would the government take. It certainly doesn’t seem consistent with cuts to taxes.”
The Treasury declined to comment.