In recent times, debt interest spending in the UK has tripled in cash terms and recently achieved a post-war record of over 10% of government revenue (OBR 2024). In 2022, the UK spent around 3.3% of GDP on net interest payments as compared with a G7 average of 1.7% (OBR 2023). As the OBR point out, UK bond yields are higher than the G7 average but the outlook for medium-term growth is similar. The higher implied growth-corrected interest rate in the UK therefore suggests that it needs to generate a larger primary surplus compared to the G7 average. Therefore, any government action that helped bring down UK interest rates relative to the G7 average would be rather welcome news.
Comparing inflation compensation in the UK versus the US
Importantly, we observe that the level of breakeven inflation embedded in UK gilt yields is high in relation to the inflation target and international peers. Therefore, there is scope to lower the debt interest bill by adopting measures that would reduce the level of inflation compensation required by markets.
To illustrate, the 20-year breakeven inflation rate in the UK is currently around 3.3%.
Of course, this is high in relation to our current inflation target of 2%. However, we need to account for a quirk whereby UK index-linked gilts compensate investors for RPI inflation for the first six of these 20 years and CPIH inflation from 2030 onwards. Given the difficulties in estimating the prospective gap between RPI and CPI inflation, note that the six-year ahead breakeven inflation rate is approximately 3.6%. This then implies that the expected average inflation compensation for the 14-year period beginning in six years that is embedded in markets is around 3.17%, which is well above the inflation target of 2%.
By comparison, the level of 20-year breakeven inflation in the US is around 2.4% (for CPI inflation), which is broadly in line with the Federal Reserve’s target of 2% for PCE inflation. Note that our conclusion is broadly unchanged if we instead calculate the breakeven inflation rate for the 14-year period beginning in six years - it is approximately 2.44%. So, the UK government currently has to offer investors inflation compensation that is at least 115 basis points above the inflation target while the US government only has to pay in line with the inflation target and this conclusion does not depend on any assumption relating to the spread between RPI and CPI in the UK.
In the jargon, there is a significant ‘inflation risk premium’ embedded within UK gilts, while investors in US Treasuries do not appear to currently demand any risk premium. Why might that be?
Before considering possible explanations for the inflation risk premium embedded within UK gilts, it is important to recall that this is a long-standing phenomenon. For example, Wickens et al. (1998) argued back then that an estimated inflation risk premium had contributed an average of about 100 basis points to nominal yields over their sample period which spanned the 1980s and 1990s.
Of course, if it were possible to reduce gilt interest rates the savings could be considerable. As a reference point, the OBR ready reckoners (as published in 2021) suggest that, over a five-year period, a fall in gilt yields of 100 basis points would save £21 billion. Moreover, the effect increases over time, so the savings beyond the five-year window should be even larger.
A ‘preferred habitat’ explanation
One plausible hypothesis is that differences in the regulatory environment relating to pension funds imply that the hedging demand from UK pension funds for index-linked gilts is of greater relative importance here than in the US. In what the literature calls a ‘preferred habitat’ framework (e.g. Modigliani and Sutch 1966, Greenwood and Vayanos 2010), higher demand for index-linked gilts in the UK from pension funds might, under certain assumptions, have the effect of boosting breakeven inflation. If the UK government believes that such a demand-supply imbalance is driving the level of breakeven inflation above what it expects for inflation in the future, they can and should save money by issuing more index-linked gilts and fewer nominal gilts. In this context, by contrast, the UK government has consciously reduced the proportion of annual index-linked gilt issuance in recent years. For example, in the five years prior to 2018-19, index-linked gilts accounted for around 25% of the government’s annual debt issuance. Index-linked gilt issuance has accounted for approximately 15% of annual gilt issuance in the four-year period since Budget 2018 (see H M Treasury 2022), when the government announced that it was seeking to reduce the degree to which the public finances were exposed to inflation shocks. It may well be appropriate to revisit the strategy enunciated in Budget 2018 and re-examine whether the overall debt interest bill might be brought down by the government being willing to shoulder greater inflation risk. However, we should note that an increase in the relative supply of index-linked gilts would bring breakeven inflation down but also somewhat boost the real interest rate. So, the savings associated with a change in relative supply would be smaller than that implied by the fall in breakeven inflation.
Might goal independence be a game changer?
Another possible explanation for a higher inflation risk premium in the UK is that markets believe that the probability of an upward revision to the inflation target is higher in the UK than in the US. This might be because the UK government sets the inflation target for the Bank of England (BoE) while, in the US, the Federal Reserve (which, hitherto, is largely independent of politicians) chooses its own definition of price stability (goal independence). It is plausible that markets believe that it is easier for politicians to amend the level of the inflation target than for independent technocrats to significantly amend their interpretation of price stability. After all, during the short reign of Prime Minister Truss, there were persistent rumours of an implicit upward revision to the inflation target as it was to be replaced by a nominal GDP target with an unrealistically high estimate of potential growth and so the 20-year breakeven inflation rate did rise as far as around 4.15% in September 2022.
It would therefore appear that a UK government that were willing to hand over the setting of the inflation target to the BoE may well be rewarded by a lower debt interest bill, and this should be actively considered. Recall that the ECB also sets its own definition of price stability and so this would only be bringing the BoE in line with two large central banks. Having said that, there are those who believe that the operational independence of the Bank of England was only feasible because Parliament retained control of the inflation target (see Stansbury and Balls 2017). Therefore, given that politicians are always leery about giving up power, it is important to remember that if a future government were to raise the inflation target, the markets would fear that the trick might be repeated and would therefore demand an even higher inflation risk premium. Consequently, in practical terms, the perceived flexibility of the inflation target may well be illusory. We recommend that the new Labour government should take advantage of its large majority and push through this change as it would signal that they were serious about entrenching price stability.
Incidentally, given the recent discussion that a newly elected President Trump might take steps to curtail the independence of the Federal Reserve, it is surprising that this is not yet reflected in the inflation compensation required by investors in US Treasuries. Perhaps investors believe that Congress would help safeguard the independence of the Fed?
Differences in monetary policy credibility
Another reason as to why the inflation risk premium is currently elevated in the UK is that it may be that the BoE itself is perceived as less credible than some other central banks. In the recent episode, wage growth expectations have been slow to moderate as they have appeared to move in line with actual inflation. In the early years of the MPC, I recall firms and unions telling me that they agreed wages on the assumption that we would achieve our inflation target and so actual inflation mattered less. Sadly, the BoE is no longer as credible as it was back then. In this regard, it has been striking that some surveys of firms suggested wage expectations were quicker to fall in the US. Of course, the BoE is already engaged in an exercise to improve its credibility, of which the recent Bernanke review might be regarded merely as a first step. It is perhaps notable in this respect that the current 20-year breakeven rate of around 3.3% is rather lower than the 4% or so rate achieved in October 2021 when markets widely believed that the BoE was ‘behind the curve’ and so progress has been made.
Should the debt management office be more activist?
As already discussed, the 20-year breakeven inflation rate can be quite volatile. For example, during the Covid-19 episode, it fell to around 2.6% at the trough. Petersen et al. (2020) argued that a significant fraction of the fall related to a decline in the inflation risk premium .If the government believes that the BoE will deliver 20-year inflation at around 2%, it should be possible to take advantage of the volatility in longer-term breakeven inflation by appropriately varying the fraction of index-linked gilts issued instead of aiming for a medium-term target level for this ratio.
Conclusion
We believe that the UK government can and should attempt to reduce its debt interest bill by allowing the BoE to set its own inflation target and to encourage efforts for the BoE to rebuild its credibility. The impact of a 100 basis point reduction in gilt yields leads to a cumulative saving of £21 billion over a five-year period. And, if the government truly believes that inflation might come in lower than currently priced in by markets, it might consider increasing the proportion of debt issuance that is accounted for by index-linked gilts and judiciously vary this fraction over time in an activist fashion.
Editors’ note: The author is a former member of the UK Chancellor’s Economic Advisory Council and the Monetary Policy Committee at the Bank of England. He writes in a personal capacity.
References
Greenwood, R and D Vayanos (2010), “Price Pressure in the Government Bond Market”, American Economic Review 100(2): 585-590.
H M Treasury (2022), Debt Management Report: 2022-23.
Modigliani, F and R Sutch (1966), “Innovations in Interest Rate Policy”, American Economic Review 56(1/2): 178-197.
OBR (2023), “The fiscal challenge of weaker growth and higher interest rates”, Economic and fiscal outlook - November 2023, Box: 5.1, page 137.
OBR (2024), “The sensitivity and volatility of debt interest spending”, Economic and fiscal outlook - March 2024, Box: 4.3, page 111.
Petersen, A, N de Vette, G Goy and D Broders (2020), “Gauging the impact of Covid-19 on market- based inflation expectations”, VoxEU.org, 19 May.
Stansbury, A and E Balls (2017), “Twenty years on: Is there still a case for Bank of England independence?”, VoxEU.org, 1 May.
Wickens, M R, E Remolona and F G Gong (1998), “What was the Market’s View of UK Monetary Policy? Estimating Inflation Risk and Expected Inflation with Indexed Bonds”, CEPR Discussion Paper 2022.
