One unforeseen economic development affecting our March 2016 forecast was the upside surprise in inflation in 2017-18 as a result of the fall in the exchange rate. This box described the effect of that surprise on receipts, spending and borrowing.

This box is based on ONS and Bank of England data from March 2018 and March 2018 respectively.

As set out in Chapter 2, the post-referendum fall in sterling helped push inflation higher than our pre-referendum forecast. Chart A shows that in 2017-18 RPI and CPI inflation were both 1.2 percentage points higher than in our March 2016 forecast.

Chart A: Exchange rates and inflation relative to our pre-referendum forecasts


As set out in our 2017 Fiscal risks report, the direct impact of an inflation shock on the public finances depends on many factors, including the extent to which it has the same effects on CPI and RPI inflation and whether any policy settings dampen pass-through to receipts or spending.

The direct effect of higher-than-expected RPI and CPI inflation would have increased borrowing in 2017-18 by around £3.9 billion relative to our March 2016 forecast on the policy settings that underpinned that forecast. That is more than explained by £4.9 billion higher debt interest spending. Index-linked gilts made up around a quarter of gilts in 2017-18 and since changes in RPI inflation feed through to accrued spending rapidly, the cost of servicing index-linked gilts increased to around a third of central government debt interest spending in 2017-18, up from a quarter in 2016-17. The direct effects of unexpectedly high inflation on welfare spending through uprating were much smaller. The continued freeze to most working-age benefits significantly dampens the effect of inflation surprises on welfare spending (with the effect feeding through instead to the real value of recipients’ benefit income). And most of the remaining benefit rates that are still linked to inflation were raised in line with September 2016 CPI inflation, which was only marginally higher than forecast.

Partly offsetting its effect in increasing spending, higher inflation would also have boosted public sector receipts by around £1.2 billion relative to our March 2016 forecast. This largely reflects higher excise duty uprating (adding £0.7 billion to receipts). However, as is traditional, the Government decided in the November 2016 Autumn Statement to freeze fuel duty in 2017-18. After accounting for this policy change, the direct effect of higher inflation boosted borrowing by £4.5 billion in 2017-18 relative to our March 2016 forecast.

This box was originally published in Forecast evaluation report – December 2018