Since the beginning of December, the yield on 10-year gilts is up from 4.2pc to 4.8pc. To put things in perspective, the yield on 30-year gilts last week hit 5.4pc, the highest since 1998, when Gordon Brown was chancellor. So far, in contrast to the Truss episode, when the exchange rate briefly touched a low of $1.03, the pound has fallen just a tad. Lest you should think that this is simply a reflection of dollar strength, though, the pound is also down a bit against the euro and the Swiss franc.
Is it Rachel Reeves’s Budget last October that is responsible for all this? It has certainly played a part, along with other government decisions such as the increase in the minimum wage and some disastrously high pay awards to rail workers and workers in the public sector. These, combined with the increases in National Insurance, have caused inflation prospects to deteriorate.
Having said that, most of what has been going on in the gilt market hasn’t been about an expected increase in the inflation rate. The real yield on index-linked gilts has risen by almost as much as the nominal yield on conventional gilts, with the implicit expectation of inflation up by only 0.13pc.
Interestingly, the same phenomenon has been observed in the US. There the reason is pretty clear: the economy remains robust. Moreover, all the signs are that under President Trump, government borrowing is going to head even higher. In these circumstances, with inflation pressures obstinately strong, the likelihood is that the US Federal Reserve is going to keep official short-term interest rates higher for longer.
It could be the case that much, if not all, of the UK bond market events derive directly from what has been happening in the US. Yet real yields do not always move in lockstep. Rather than the UK market following on blindly from the US, perhaps both markets are responding to similar forces.
The difference, however, is that whereas growth is strong in the US, it is anything but in the UK. In these circumstances, you would normally expect inflation pressures to wilt and the case for lower interest rates to strengthen.
This is where the Budget and other measures come in. Planned government borrowing has been increased and the markets may be doubting the Government’s resolve and ability to bring the public debt ratio down. Also, because inflation will be higher than it otherwise would have been over the next year or so, the Bank of England may be inhibited from cutting interest rates. Indeed, in order to bear down on inflation it may need to keep real short-term interest rates higher than it otherwise would have.
What will the consequences be? First, if bond yields stay high and the prospect for interest rate reductions sour, then this will do the economy no favours at all, thereby making the fiscal position even worse.
Second, higher gilt yields and interest rates will increase the Government’s debt interest bill. We are now living through the consequences of having allowed government debt to surge to such high levels.
Third, when the OBR produces its next assessment of the fiscal position, scheduled to be published on March 26 in the slot which used to be called the Budget but is now downgraded, supposedly to a routine review, it may well say that the Chancellor is on course to break her newly minted fiscal rules.
In this case, what would the Chancellor do? She cannot just ignore matters and let borrowing surge. That would be a recipe for more trouble in the gilt market. Some analysts are saying that she would be forced into increasing taxes. She may well do a bit of this. Nevertheless, I doubt that she would impose large tax rises – not least because of what she has said, but more importantly because of the effect that this would have on the economy.
The only remaining option is to reduce government spending. This is the route I think she will choose. I suspect, though, that rather than cutting spending in the immediate future, she will be tempted to reduce the growth of spending in the outer-years of the forecast period. In short, she would be hoping that something will turn up.
This approach to economic management is the well-known “Micawber strategy”, after the famous economist of yore, Wilkins Micawber, a character in Dickens’ David Copperfield. The trouble is that in this case the thing that turns up could be gilt yields.
Surely things can’t go on like this. In the early 1980s, the French president François Mitterrand tried to follow a socialist economic agenda. At the time, this was dubbed “socialism in one country”. After a few years, however, Mitterrand was forced to change course.
Could the same thing happen here? The financial markets are surely delivering a painful lesson to this government about how finance works. I wonder if, as they see the real economy wilting under the weight of tax, regulation and a collapse of confidence, ministers might begin to understand how the business world works too?
Of course, the Labour government wants to follow a different course from the previous Conservative government. But it seems not to have noticed that, as far as economic policy is concerned, that government was Conservative in name only. It followed the normal Labour agenda of higher spending, higher taxes and higher debt, along with increased regulation. In effect, intentionally or unintentionally, the Conservatives stole Labour’s clothes. There is no scope to go further down this road. The only way forward is to turn back.
Roger Bootle is senior independent adviser to Capital Economics and a senior fellow at Policy Exchange. roger.bootle@capitaleconomics.com
