Cost of living: Grim economic outlook should worry chancellor more than debt costs, economists warn

The cost of living crisis is a bigger short-term threat to economic health than higher interest payments for the public debt, economists told The Independent

Chancellor Rishi Sunak should be more wary of recession risks than the mixed impact of higher inflation on the public debt, economists said (PA Wire)

The chancellor should be more worried about the risk of the cost of living crisis plunging the UK into a recession later this year, than higher debt costs, economists warn.

Rishi Sunak faces a trade-off between trying to trim the public debt or easing pressures on households when he delivers his spring statement at the dispatch box on Wednesday.

Public sector borrowing was almost £26bn less in the financial year to February than forecast by the Office for Budget Responsibility in October. This, combined with a higher tax take than expected, gives the chancellor sufficient fiscal headroom to ease the cost of living sting for households, economists and analysts said.

Still, some are concerned that the Treasury will only make tweaks to fiscal policy amid an ongoing real-terms drop in benefits, and as it introduces a hike in national insurance contributions equivalent to 10 per cent for most earners.

“If you don’t cut taxes and increase benefits you increase the risk of a recession later this year. That will cause far more harm to the economy and the public finances,” Julian Jessop, an independent economist and fellow of the Institute of Economic Affairs, a think tank, told The Independent.

The Resolution Foundation has also warned that the risk of a recession “is looming into view” amid a worsening cost of living crunch.

It comes as a clutch of international institutions including the global lender of last resort, the International Monetary Fund, have warned that elevated energy costs and the wider economic fallout from Russia’s invasion of Ukraine pose risks to global growth.

“Price shocks will have an impact worldwide, especially on poor households for whom food and fuel are a higher proportion of expenses,” the Washington-based lender said earlier this month. Meanwhile, Fitch Ratings, a credit-ratings company, has warned of a deteriorating outlook for global growth as inflation returns “with a vengeance”.

Higher inflation can lead to some higher interest repayments on debt which is directly linked to measures of price growth in the economy – about a quarter of UK gilts are linked to the Retail Prices Index (RPI).

Mr Sunak said on Tuesday that with inflation and interest rates on the rise, it is “crucial that we don’t allow debt to spiral and burden future generations with further debt”.

But inflation also has a windfall effect on the public purse, as departmental budgets are fixed in cash terms, rather than keeping pace with prices. Higher nominal GDP growth also results in a higher nominal tax take.

“There are factors pulling in both directions with inflation. It costs more money to finance the stock of debt, but the tax take also increases,” said Mr Jessop. “But in the short term, even without the windfall, it makes sense for borrowing to take the strain.”

Without changes to the current course of fiscal policy, Mr Sunak would effectively be tightening the public purse strings.

A cut in fuel duty, as signalled by Mr Sunak, and a small increase to the threshold for national insurance contributions, would do little to address the overall cost of living crunch, economists believe.

Although inflation has risen sharply, and is set to remain elevated, with the Bank of England warning it could stay above 8 per cent for three months from April, before a higher peak in October, interest rates are still only just returning to pre-pandemic levels.

That’s significant for the three-quarters of the UK’s debt which is not linked to the RPI, a volatile and imperfect measure of price growth.

“On debt, and debt interest, it’s good not to lose our sense of perspective,” said Isabel Stockton, research economist at think tank the Institute for Fiscal Studies. “While we should certainly keep an eye on that, we shouldn’t lose our heads on the interest costs just yet.”

Meanwhile, there is a risk that a failure to take more radical action could push the UK into recession this autumn, if households drastically cut back on non-essential spending.

“What we do know is that consumer confidence has plummeted,” Jonathan Portes, professor of economics at King’s College London, told The Independent. This can signal cutbacks in consumer spending – a key driver of GDP growth in the UK, though it is an imperfect recession indicator.

Mr Portes has warned that the spring statement could be read as “austerity by stealth” if the chancellor does not use some of the windfall from a higher tax revenue due to inflation, to ease real-terms cuts to the public sector and pressure on households.

With inflation cutting workers’ wages in real terms, even as it has an overall positive effect on the public finances, the economy faces a tough few months ahead with another hike in energy bills this autumn.

“A lot of risks are on the downside,” Mr Portes said.