Debt-servicing costs have thus become one of the biggest sources of risk to the fiscal outlook; interest rate assumptions play a crucial role in determining the Government’s wider room for manoeuvre on tax and spend.
In a policy paper published in December last year, the Treasury offered the following observation on how fiscal policy might affect interest rates.
“An unanticipated increase in spending, or reduction in taxation, that is funded by additional government borrowing, will increase the level of demand in the economy, thereby increasing inflationary pressures, which may lead to an inflation-targeting central bank increasing interest rates.”
The worry is that borrowing more to fund supposedly growth-enhancing policy will simply end up negating itself by prompting higher interest rates than otherwise.
Putting flesh on the bones of this generalisation, the Treasury paper calculated that every 1pc of GDP in spending (around £25bn at the time) would result in an increase in interest rates of between 0.6pc and 1.25pc. Even at the lower end of the range, that’s a big number – especially if you happen to have a large mortgage.
However, there was an important caveat: no consideration was given to the potential supply-side benefits of borrowing for investment. The impact on interest rates would be smaller, the Treasury said, where policy had a material benefit for the supply side of the economy.
In modelling the impact of higher borrowing, moreover, the Treasury assumes that it would be split evenly between so-called annually managed expenditure (welfare and pensions), departmental spending, capital spending and tax cuts. In the Treasury model, in other words, only a quarter of the money borrowed would be spent on capital investment, with the bulk funding current consumption.
But that’s not what Reeves appears to have in mind, observes Simon French, chief economist at Panmure Liberum. Instead, she wants to borrow only to invest, or at least that’s what she says.
If that’s the case, then we can be less concerned about the impact of a big rise in borrowing on interest rates. It’s the impact of borrowing to spend on demand, not supply, that would worry the Bank of England. If the intention is to borrow only to invest, then the effect on rates is unlikely to be as big.