ECB can take time on policy, policymaker Nagel says
The ECB cut interest rates on Thursday for the eighth time in a year but signalled at least a policy pause next month after inflation returned to its 2% target.
Nagel, who is also the president of Germany's central bank, said rates are now at a neutral level - central-banker language to describe policy that neither expands nor brakes the economy.
"We are no longer restrictive. I believe that we can now take the time to look at the situation first. We now have maximum flexibility at this interest rate level," Nagel said in a live interview on Deutschlandfunk radio.
The ECB has lowered borrowing costs eight times, or by 2 percentage points since last June, seeking to prop up a euro zone economy that was struggling even before erratic U.S. economic and trade policies dealt it further blows.
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In the teens of this century, interest rates fell to very nearly zero and in some countries to less than zero. We got used to these very low rates very quickly – but in the long historical context, it was unprecedented for rates to stay so low for so long. Aside from discouraging and penalising savers, it encouraged governments around the world to borrow and spend. The full knock-on effects of this policy will be studied for years, but my bet is that economic historians won't be kind. Since late 2022, interest rates have risen back to near 'normal'; in the UK's case, first up to 5pc and now hovering around 4pc. These are not high rates by historic standards – the average Bank Rate over the past 50 years is 6.2pc – but the UK is now paying the price in its debt interest bill which, along with interest rates, has rocketed. What do today's numbers look like? The Government says it paid £124.7bn in debt interest on outstanding debt of £2,925bn in 2024-25. GDP was £2,895bn, so debt interest as a percentage of GDP was 4.3pc – but as a percentage of Government expenditure (£1,285bn), it was 9.7pc. That puts debt interest in third place of spending categories, behind social security (including the state pension) and health and social care but ahead of education and way ahead of defence, which is about half the debt interest figure. It gets worse... If this sounds bad, it is. But there's much worse. The Government completely ignores a huge amount of interest which it is incurring every year in addition to these published figures. To explain this, I will start by using a simplified example. Suppose you borrow £1,000 and instead of your lender asking for interest every year, it says, 'don't worry about paying us interest along the way, just pay it all at the end'. If you borrowed £1,000 for 20 years and supposing the interest rate was 5pc, the lender would ask for £2,650 at the end – the £1,000 you initially borrowed and £1,650 in cumulative interest. That equates to 5pc compound interest over the whole period. Sometimes money is borrowed in this way in the financial markets and these instruments are called 'zero-coupon deep-discount bonds'. For the borrower it has the advantage of requiring no cash payments for a long time; for the lender, locking in an agreed long-term interest rate without the complication of re-investing interest receipts. The lender has to weigh up whether the borrower is fully creditworthy over this period, however, as there are no interest payments to reassure them (and keep the debt from spiralling). The elephant in the room The Government is borrowing money in this way in two very different contexts, but both on a very large scale. The first is through their issuing index-linked gilts. 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The interest on the borrowed money in 2024-25 amounted to some £20bn of the £125bn total debt interest – and just to note, this is interest on debt, not a subsidy to the UK banking sector. But to add a further twist, about £18bn of the £125bn is interest on the public sector-funded pension liability – and for fairness we should really knock this off the interest bill as it is covered by equivalent income from the £390bn or so invested in the Local Government Pension Scheme. So let's say that the actual interest on the Government's debt pile is £107bn. But these debt interest calculations are missing a vital ingredient. The elephant in the room is the unfunded public sector pension liability. It is a contractual obligation of the Government which it chooses to treat as 'conditional', both in its accounts and the new 'public sector net financial liabilities (PSNFL)' measure of public debt. The irony – which seems to have been missed by most commentators – is that funded public sector pension obligations (essentially the Local Government Pension Scheme) are included in both the accounts and the PSNFL, but exactly the same pension promises guaranteed by HM Treasury (unfunded pensions) are excluded from both. This is because the Government has chosen to use a European accounting standard for this exercise rather than an internationally-agreed standard, and European countries have overwhelmingly large unfunded pension liabilities which would be politically unacceptable to put on government balance sheets (as it would send most states bankrupt). The UK doesn't have quite the same existential pension issues as Europe, but it has adopted this standard somewhat cynically in my view. Because it treats unfunded government pension obligations as conditional, they escape being accounted as a formal liability. Nothing could be further from the truth for unfunded UK public sector pensions, which are anything but conditional, so in my opinion we need to add the interest that accrues on pension liabilities in the government debt interest total. This is the second way in which the Government is borrowing money by rolling up interest and paying it at the end. When an employer makes a pension promise, their actuary calculates the amounts that are going to be paid to each pensioner in the future (up to 80 years ahead for a 20-year-old employee) and then discounts all those future payments to today's values by the prevailing interest rate. This discounted value is what the pension fund should have in assets to pay the future pensions if it invested those assets. We know that in this case there are no assets, so with each year that passes, the amount owing goes up by the interest rate with no corresponding gain from investments. This may all sound very esoteric but the numbers definitely aren't. The interest which the Government paid in 2024-25 just on its unfunded public sector pensions was £63bn. Each year a small proportion of this interest bill is paid (by the act of paying pensions in that year) but the rest is rolled up, ensuring an ever-increasing public sector pension liability. So adding this to the £107bn we calculated earlier, we get an annual £170bn interest cost. That's nearly as much as we spent on the NHS last year (£178bn). To frame one possible doom-loop scenario, imagine a sustained rise in inflation to 10pc (we've just been there after all) with a commensurate rise in the Bank Rate. That would put up debt interest to over £300bn – overtaking both health and welfare spending to be the largest category of expenditure. This level of debt interest would be close to the point of no return, where the costs of indebtedness were so high that we would be permanently unable to balance the books without default or expropriation. There lies economic and social ruin.
