Rising debt and interest rates

To investigate the long-term effects of a sharply increasing debt-to-GDP profile on debt financing costs and the wider economy, we use our UK Overlapping Generations model (UK OLG).^a OLG models are useful for analysing economy-wide impacts of long-term trends, as they explicitly model households of different ages who make forward-looking decisions.

As in our analysis of the long-term impact of population ageing on asset demand and rates of return for the 2025 Fiscal risks and sustainability report (FRS),^b we use a version of the UK OLG that sets interest rates based on domestic savings matching investment. While some models of an open economy, like the UK, fix interest rates at a global price, that would not account for the impact of government debt issuance on the yield the government needs to offer on that debt. Rising public debt is a widespread phenomenon across advanced economies, so similar dynamics may affect global bond yields as well. And our 2025 FRS analysis suggested that foreign investors absorbing more gilt demand, as the UK defined benefit pension system winds down, may make gilt yields more sensitive to issuance, rather than less.

The UK OLG model’s default settings assume that the government debt stock remains constant at current values of around 95 per cent of GDP across its entire time horizon.^c We use two alternative debt endpoints in the UK OLG to examine the effect of these higher debt levels on gilt yields and economy-wide outcomes. One is our baseline scenario described in paragraph 5.10, in which debt rises to around 300 per cent of GDP by 2075-76. The other is the higher medium-term primary deficit plus shocks scenario described in paragraph 5.13, bullet point 2, in which debt rises to around 540 per cent of GDP.

In the UK OLG model, a higher stock of government debt means more household savings are absorbed by government bonds, leaving less available for private capital investment. As funding for private sector capital becomes scarcer, this raises its cost. Real interest rates rise to incentivise additional household saving, beyond the portion increasingly directed towards public debt. In the baseline scenario for government debt, the UK OLG equilibrium interest rate would need to rise by 2.2 percentage points relative to a stable debt scenario by the end of the projection (Chart F). Under the higher medium-term primary deficit plus shocks scenario, this difference rises to 5.5 percentage points. This raises the growth-adjusted interest rate (r-g, explained in greater detail in Chapter 2), which rises to 2.7 and 6.0 per cent in each scenario, respectively.

Chart F: Interest rates under alternative assumptions for the debt-to-GDP ratio

Note: r-g is the growth-adjusted effective yield on government debt.

Source: OBR

Higher real interest rates would also have impacts beyond debt servicing costs. In the baseline scenario, reduced capital deepening lowers the level of productivity by 7 per cent, in turn cutting GDP per person by 14 per cent relative to the stable debt steady state. These effects are not captured in the baseline scenario in this report but demonstrate the risks around it, which we explore further via productivity scenarios (described in paragraphs 5.17 to 5.20).

This analysis illustrates the potential feedback loop between an unsustainable debt path and the cost of servicing that debt, which can exponentially ratchet up the debt-to-GDP ratio. In reality, debt markets typically exhibit highly non-linear behaviour, driven by factors outside the scope of this analysis including changes in market sentiment, rollover risk, and other potential tipping points.^d These can lead to abrupt and large increases in interest rates and, though very difficult to predict, they generally become more likely as the stock of debt grows larger or moves onto an unsustainable path. We previously explored the potential implications of a loss of investor confidence in our 2021 Fiscal risks report.