You might think that Chancellor Rishi Sunak had pulled off quite a conjuring trick with last week’s Budget.
With public spending soaring, most notably on the health service, and substantial tax rises, Sunak has adopted a strategy more reminiscent of Gordon Brown than Margaret Thatcher, and a million miles from that of George Osborne.
At the same time, he has promised to reduce the national debt relative to the size of the economy, so reassuring his fellow Conservatives that he is, at heart, a prudent chap.
There is even a political sweetener. The Chancellor has let it be known that he will cut taxes as soon as he can – perhaps even before the next Election.
You might think that Chancellor Rishi Sunak (pictured during the G20 summit on Saturday) had pulled off quite a conjuring trick with last week’s Budget
Yet for all his polished confidence, we should be aware he is playing a dangerous game.
At the heart of it is a gamble on interest rates and inflation. But particularly interest rates.
Sunak’s trick depends on interest rates staying low, despite rising inflation. (Low rates obviously hold down borrowing costs.)
But this will not be easy.
For if inflation continues to climb – as it will this winter – the main weapon the Bank of England has to control it is to raise interest rates, which will be painful for millions of us, including the Chancellor. The key point about inflation is that a little bit of it can actually help. In fact, governments rely on inflation to whittle down the real value of the national debt.
This was how Sunak managed to pull off last Wednesday’s Budget.
Britain is going to run fiscal deficits – spending more than its income – for years to come. Yet, magically, the size of the national debt relative to the size of the economy is still scheduled to shrink.
That will be partly thanks to the growth of the economy, but also because inflation is eating away at the real value of the national debt.
In other words, the Government wants a little inflation – not so much that people really notice – to reduce the value of the money it has borrowed.
But this is a strategy that relies on keeping interest rates down. If interest rates go the other way and start to rise above inflation, the reverse starts to happen and the debt becomes ever more burdensome.
Yet for all his polished confidence, we should be aware he is playing a dangerous game. At the heart of it is a gamble on interest rates and inflation. But particularly interest rates. Sunak’s trick depends on interest rates staying low, despite rising inflation
We all know this. In a world of high interest rates, it becomes a nightmare to pay the interest on the debt, let alone pay back the original money, as anyone who struggled to pay mortgage rates of 15 per cent and more in the 1980s will recall.
Remember the expression ‘negative equity’? That was when the value of your home fell below the value of the mortgage you had taken out on it.
If you could hang on long enough, then property prices recovered and you were OK. Sadly, many hard-working families could not do so and lost their homes simply because they happened to buy them at the wrong time.
But this not just a matter for us as individuals. What happens to inflation and interest is crucial to the finances of this Government, and perhaps to its political future too.
In practical terms, if interest rates go up sharply, the Chancellor will be unable to cut taxes ahead of the next General Election.
Rather, he (or maybe she – reshuffles have been known to happen) might have no choice but to raise taxes instead. This Government is, after all, a borrower on an eye-watering scale.
At the end of the last financial year, Britain’s accumulated debt was £2,223 billion.
If that debt mountain becomes more expensive to maintain due to higher interest rates, our taxes will be needed to pay the bill.
To put it in pounds and pence – a one per cent increase in interest rates will cost the Treasury £18 billion in the first year alone.
So you can see why the Government is desperate to hold rates down. But the truth is Sunak has only limited control over his borrowing costs.
For if inflation continues to climb – as it will this winter – the main weapon the Bank of England has to control it is to raise interest rates, which will be painful for millions of us, including the Chancellor (stock image)
In reality, interest rates are determined by global forces that no one fully understands.
If those highly-paid people in banks and other financial institutions could predict them confidently, they would be even richer than they are already.
The central bankers like to portray an air of knowledge and calm, but they also get things spectacularly wrong.
In February, the Bank of England expected that ‘inflation should return to around our two per cent target later this year’. Now it is going to be five per cent? Or six per cent?
If that sounds alarmist, note that the most recent inflation number for US inflation is already 5.4 per cent, and for Germany 4.5 per cent. Both are expected to go higher.
And who knows what might happen to inflation a couple of years ahead? It could go back to the two per cent target level adopted by the UK and most other developed countries, as some central bankers still hope. Or it could get stuck at a much higher level as wages rise.
We might or might not get the first rise in official rates from the Bank of England this week, but already the markets are moving.
On Friday, several banks announced that they were raising mortgage rates, and the message to would-be home-buyers must surely be to grab the loans while they last.
It is, if you think about it, a bizarre state of affairs that it should be possible to get a mortgage at less than one per cent with a two-year fix when inflation this winter is predicted to rise to about five per cent.
That cannot last.
It is equally odd that people should get only 0.5 per cent, or less, on their deposits in a bank account. That cannot last either, though this rip-off of savers has already gone on far longer than most of us would have believed. So what might this mean for interest rates? Let’s say inflation settles at about three per cent, and let’s look at history.
Back in 2006, when Gordon Brown was still Chancellor, the consumer price index averaged 3.2 per cent.
And the Bank of England base rate? It started the year at 4.5 per cent and ended it at 5 per cent. That is normality. Interest rates that are higher than inflation.
What is happening now is far from normal.
Unfortunately for Sunak, what happens next depends on neither the Chancellor of the Exchequer nor even the Bank of England. It’s what happens to global markets that will count.
Interest rates everywhere will inevitably start to rise, although other countries are in much the same boat as us and the authorities will do their damnedest to slow the climb.
They might get away with it. Holding interest rates below inflation for another two or three years would be enough, if not to repair national finances, at least to patch them up.
But they might well find that their hand is forced by rising inflation.
The bottom line is that it is certain that we are going to get somewhat higher interest rates.
But keep your fingers crossed that they don’t really take off, because if they do Sunak’s conjuring trick will fail. And if it does fail, it won’t just be the Government that will suffer. We all will too.