The Treasury coordinates the production of our debt interest forecast based on our assumptions about interest rates and forecast for RPI inflation. We discuss these forecasts at challenge meetings where we scrutinise the latest data and the effects of our assumptions and judgements.
The mechanics of the debt interest forecast are somewhat different to other AME forecasts because of the interactions between the central government net cash requirement (CGNCR) – which we derive from our full fiscal forecast – and our gross debt interest forecast. This means that we need to iterate the forecast until the CGNCR and the debt interest forecast converge on their final values. This is known as the ‘debt interest loop’ and run in the OBR at the very end of our fiscal forecast process. The following diagram summarises this process:
Central government debt interest payments (net of the effect of the Bank of England’s Asset Purchase Facility (APF) holdings of gilts) are forecast by applying interest rates to the stocks of different liabilities.
Our debt interest forecast process starts with estimates of the stock of different types of debt on which government must pay some form of debt interest. These include:
- conventional gilts;
- index-linked gilts;
- the assets and liabilities of the APF; and
- other financing products (such as Treasury bills and NS&I products).
The largest component of debt interest is the interest paid on conventional gilts. For the existing stock of conventional gilts, payments are known and fixed. By contrast, estimates for interest payments on existing index-linked gilts and for all new debt issuance can be subject to bigger revisions due to changes in our economic and fiscal forecasts (including changes in RPI inflation, interest rates and the net cash requirement – a measure of the deficit).
We forecast changes to the various stocks of debt by considering the gilts and other liabilities that will become due to be redeemed, and the additional debt issuance that will be required to cover the net cash requirement for each year, plus the redemptions of the existing stock.
We then have to make assumptions about the composition of gross financing each year to cover the cash deficit and redemptions, and the interest rates that will apply to the new debt issuance. These interest rates are derived from financial market expectations and our RPI inflation forecast (for index-linked gilts).
The debt interest forecast is expressed as net of the effect of gilts held by the APF. The APF receives coupon income on the gilts it holds, while the Bank pays Bank Rate on the reserves it created to finance the asset purchases made by the APF. The coupon payments cancel out within the public sector, so this debt is in effect financed at Bank Rate. Consistent with statements from the Bank, we assume that gilts held by the APF will not be sold actively during the forecast period, and will only be run down through redemptions once Bank Rate rises to at least 2 per cent (which also was not expected to happen during the period covered by our latest forecast).
Our central government debt interest forecast includes interest payments made by UK Asset Resolution (UKAR) and Network Rail, which are both classified as parts of central government by the ONS, as well as other smaller payments, such as interest on finance leases.
Box 4.4 of our March 2015 Economic and fiscal outlook contains further explanation of how our net debt interest forecast is constructed.
Main forecast determinants
The main determinants driving our debt interest forecast are:
- our forecast for the Retail Prices Index that determines the accrued debt interest payments on index-linked gilts;
- our market-derived assumptions for conventional and index-linked gilts rates that are used to forecast debt interest payments on conventional and index-linked gilts. We use an average conventional gilt rate obtained combining the yield on a short, a medium and a long-term government bond with the proportions of each in total issuance consistent with recent outturns and government debt management policy. Our real index-linked gilt rate is from a long dated index linked gilt;
- market expectations for Bank Rate that are used to forecast the debt interest payments on the APF’s loan; and
- our market-derived assumption for short-term market interest rates that is used to project forward payments on Treasury bills and other short-term debt instruments. This is typically very close to Bank Rate.
The forecast is also driven by the central government net cash requirement (CGNCR) that determines the net amount of new debt that must be issued on which additional interest payments must be paid. This is added to the new debt issuance associated with the known amounts of gilts that are due to be redeemed to get to gross debt issuance.
Main forecast judgements
Much of our debt interest forecast reflects the consequences of judgements we make about other parts of the forecast – about inflation, what source to use for interest rate assumptions, and the overall fiscal forecast that drives the cash requirement. The remaining judgements that are specific to our debt interest forecast are:
- the proportions of different types of gilts that will be issued and whether this is skewed towards shorter- or longer-term debt, index-linked gilts and so on; and
- the size and composition of the gilts and other assets held in the APF and whether or how they will be replaced when gilts reach maturity and are redeemed.