First published in the Telegraph on 20 April 2010
I doubt any of the politicians will spend much time today worrying about the increase in inflation just reported by the Office for National Statistics. In the grand scheme of things, with the country facing a serious economic crisis and a possible fiscal one, you might be tempted, if you’re a politician on the stump, either to paint it as a sign that things are starting to improve (after all it could be construed as a sign of recovery) or as representing further pressure on household finances.
While both of those have elements of truth about them (though, as I’ve said before, it would be extremely foolhardy to assume we can now declare victory over deflation) if I were one of the party leaders I would be worried about inflation for another reason. Very simply, the minute the Bank of England even thinks about lifting interest rates (and I should add I don’t think this is an imminent prospect), it will set off a chain reaction which could make a fiscal crisis of the Greek variety all the more likely.
The reason is rather technical, and is to be found in the way the gilt market works.
Here’s the thing: markets don’t just think of interest rates on a immediate basis (in other words what rate it costs to borrow money overnight) – they think of them over a long period of time: what’s the going rate to lend money for one week? For one year? For 50 years?
Usually the longer you are lending money, the higher the premium you charge, for obvious reasons. So, for instance, the current cost of borrowing money direct from the Bank of England is 0.5pc (of course this is only an option available to banks rather than individuals); the cost of borrowing overnight (Libor) is just a sniff above at 0.65pc; the rate on the typical two year UK government bond (gilt) is 1.176pc. The rate on the benchmark 10-year bond is at 4pc. (In the UK the very longest-dated rates are actually a bit lower but that’s a story for another day.)
The way the costs of borrowing vary throughout time is called the “yield curve”, and although there are different considerations about lending over various different timespans, the thing to remember is that a change in the interest rate anywhere along the curve can send a chain reaction down the rest of the line. And the key point is that right now because the most immediate interest rates are so low, this is holding down the whole rest of the yield curve.
In other words, it is highly likely (and I take this from technical experts in the market rather than mere supposition) that the rate on the average 10-year government bond would be significantly higher were it not for the extremely low level of Bank of England interest rates. Even now, the disparity between the overnight lending rate and the 10-year rate is the biggest it has been in history (geeks call this the “steepness of the yield curve”). What this implies is that investors are anticipating either a sharp increase in inflation and interest rates and/or a deterioration in UK government creditworthiness over the next 10 years.
Where does all of this leave us? Simply: in a world where a sniff of a hint that the MPC may soon consider lifting borrowing costs would suddenly unleash the yield curve. Some think this could, in pretty short order, send the 10-year gilt yield up by a full percentage point to 5pc.
Seems pretty academic? Only until you remember that the moment the government starts having to pay higher interest rates, it starts eating, deeply, into the public finances. The Government is already projecting that within a few years it will be paying more than 10p in every pound it gathers in taxation on interest payments on the national debt (and check out this from the Taxpayers’ Alliance showing that the amount a household pays on interest on the national debt is outstripping mortgage payments).
Should the average interest rate on government debt (which lest we forget is chain-linked to the Bank of England rate through those technical factors I’ve discussed above) increase significantly, Whitehall might soon find itself struggling to pay the debt. That is what happened in Greece. The government was predicating its austerity plans (the ones which involved 10pc cuts to public servants’ salaries and sparked riots) on being able to borrow at below 5pc. Suddenly, when the market started charging a higher rate, it had to scream out for help.
Now, we’re not yet anywhere near there, but look at the reaction of the 10-year gilt this morning.
It has barely risen above the 4pc mark in recent days, despite all the hoo-hah about the LibDems. But the merest sniff of inflation, and it shoots up above 4pc. Just think what it might do when the Bank starts lifting rates. Of course, this is not an issue which will be discussed at the election, but it plays right into the debate over the state of the public finances, the dilemma over the part the Bank will play in this, the question of central bank independence and the fate of the UK economy. You have been warned.