Higher rates of inflation increase debt costs for government, BBC reports

A recent report from the BBC outlining data from the Office for National Statistics shows that rising inflation rates have led to government debt repayments increasing in the month of January.

The UK government borrowed record amounts throughout the COVID-19 pandemic, resulting in total public sector debt reaching a peak of £2.4 trillion. Although this figure may seem like the government is irresponsible with its budget, such a large deficit is to be expected during an economic downturn.

In the case of COVID-19, the threat of infection from the virus yielded mass lockdowns in many nations including the UK, as a result of this, the confidence levels of economic agents such as businesses and consumers fell, thus leading to a reduction in investment as well as consumption.

Due to both of these being components of aggregate demand and large ones at that, considering consumption accounts for 66% of total demand for goods and services in the UK economy. Consequently, these reductions in confidence yielded an overall contraction in aggregate demand levels thus causing a fall in Real GDP, commonly referred to as economic contraction.

Hence, due to a reduction in consumption, businesses see lower profits and allocate fewer resources towards scaling production as a result of the lower profit incentive. In fact, during economic downturns, businesses may see losses, thus resulting in businesses cutting back on factor inputs, such as labour, which leads to rising unemployment rates.

Fortunately, in the UK, the government learnt their lesson from the Financial crisis and to prevent a de-multiplier effect, the Furlough Scheme was introduced to ensure that unemployment levels within the UK stabilised as laid-off workers still received regular injections of cash to retain liquidity within the economy.

However, the opportunity cost of this decision is that the Furlough scheme cost £700 billion, this paired with a myriad of other expenses such as the track and trace programme as well as reduced tax revenue from sources such as income tax due to higher unemployment rates lead to government spending being higher than tax revenues.

As such, this leads to a budget deficit, one which swelled to £2.4 trillion during the pandemic. Once again, whilst this figure is large, the opportunity cost of not spending would have been a more drastic economic downward spiral that would have gotten worse and worse. The decision to intervene by the government, although costly, was the best decision out of two bad, yet unavoidable outcomes.

Nevertheless, the cost of borrowing must now be borne upon by the government. Interest payments hit £6.1bn last month, the highest amount for January since records began in April 1997 and up from £4.5bn last year.

The reason for these higher interest repayments is due to the fact that these repayments are pegged to the UK’s RPI figures. The RPI is the Retail Price Index, a measure of inflation that is more suitable for the UK as it includes increases in council tax as well as mortgage interest repayments.

As of now, the UK’s RPI figure stands at 7.8% in January. This figure is also likely to rise further as the CPI figure, a component of the RPI is predicted to rise to 7.25% in April; a large increase considering the CPI inflation rate is currently at 5.5%.

Although this does mean the UK government will see higher debt interest repayments, a strong economic recovery is likely to follow soon as cost-push pressures will self-correct by the free market. The relaxation of remaining Omicron restrictions will also further boost aggregate demand, leading to a positive output gap that will increase VAT tax revenues for the government.

This will aid in the repayment of these rising debt costs, which will add an extra layer of security for the government's finances and fiscal status as in February, the government reported a budget surplus of £2.9 billion from £2.5 billion in January, showing signs of strengthening fiscal security that can be enforced with further raises in government tax revenues.


Written by Hubert Kucharski


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