Inflation, not Andy Burnham, is the culprit behind high Gilt yields
Gilt Yields have more to do with inflation than the future of the Labour Party, says Tomasz Wieladek
The debate about the future of the Labour Party’s leadership has revived a familiar narrative: that high Gilt yields are the verdict of financial markets on prospective changes to the government’s fiscal plans. The implication is that only fiscal restraint can bring yields down again. This argument is too simple. It misdiagnoses the problem and the cure.
Gilt yields do not move in isolation. They are anchored, in part, to the yields of other major economies. That anchor has shifted substantially. To blame domestic politics for the level of yields, without acknowledging what is happening in global bond markets, is to only tell one side of the story.
German Bund yields, long suppressed by scarce supply and the European Central Bank’s quantitative easing programme, have risen sharply. The reform of Germany’s debt brake has opened the fiscal taps, releasing ample new Bund supply onto the market.
Meanwhile, Japan’s monetary policy normalisation and the Bank of Japan’s own quantitative tightening have pushed Japanese Government Bond yields to levels not seen in 30 years. Japanese fiscal expansion is adding further upward pressure.
And the Federal Reserve may yet have to raise rates again in response to renewed inflationary pressure at home. All of these forces are keeping Gilt yields elevated, regardless of what happens in Westminster. As President Kennedy once said: A rising tide lifts all boats.
Yet that global explanation does not account for everything. A significant and persistent spread has opened up between Gilt yields and their international counterparts over the past couple of years. The last time this gap was this wide was in the 1990s, before the Bank of England was granted independence
Yet that global explanation does not account for everything. A significant and persistent spread has opened up between Gilt yields and their international counterparts over the past couple of years. The last time this gap was this wide was in the 1990s, before the Bank of England was granted independence. That is an uncomfortable historical parallel. That should focus minds considerably more than the question of who leads the Labour Party.
Divergence
The gap has its roots in the UK’s combination of weak growth and persistently high inflation. Since 2022, UK inflation has been above 3 per cent for roughly 75 per cent of the time. In the Euro Area, the equivalent figure is closer to 40 per cent. This is a striking divergence, and it matters enormously for how investors price inflation risks in UK government debt.
Take the recent conflict in the Middle East as an example. It has stoked fresh concerns about energy supply and commodity prices. Gilt yields rose with Bund yields during this period, a reflection of the global factors at play. But for every one per cent rise in the oil price, the reaction of Gilt yields is 60 per cent larger. Clear evidence that investors are concerned about excessive inflation in the UK.
The UK has been hit by a succession of severe exogenous shocks: the pandemic, the energy crisis, supply chain disruptions and geopolitical turbulence. Therefore not all of the blame for persistent inflation can be laid at the Bank of England’s door.
The structural factors that kept inflation low for two decades, such as cheap energy, globalisation, and abundant EU labour have gone sharply into reverse. These are global forces acting on a particularly exposed economy, not the consequences of domestic policy mistakes alone.
But whatever its causes, persistently above-target inflation has eroded investor confidence in the credibility of the 2 per cent inflation target. The spread between Gilt yields and comparable global interest rates reflects, in large part, the inflation premium that investors now demand as compensation for that lost credibility. Credibility, as any central banker knows, is easily lost and takes years to rebuild.
This has a direct and important implication for policy. Those who argue that cutting public spending is the key to lower Gilt yields are focusing on the wrong variable. The spread that makes Gilts so expensive is not primarily a fiscal credibility, but rather an inflation credibility premium.
Restoring confidence that inflation will reliably return to and stay at 2 per cent would do far more to bring down the Gilt yield curve than fiscal adjustment.
The debate about Labour’s leadership and its spending plans is legitimate. But it should not crowd out the harder, more important question: how does Britain rebuild its reputation as a country where inflation stays under control? That is where the real prize lies for borrowing costs, for growth, and for the public finances.
Tomasz Wieladek is chief European macro economist at T. Rowe Price