A significant financial challenge is being faced by countries across the Western world, as many are considered to be over-indebted. In theory, a path out of this situation could be achieved through economic growth or by reining in fiscal deficits. However, the richer countries have experienced a dismal growth record in recent times. Furthermore, as was evidenced by the recent fall of French Prime Minister François Bayrou, it has been observed that there is no public willingness for austerity measures. This situation has been described as a “siren of inflation,” and whether countries will succumb to its call is believed to depend on the strength of their commitments to price stability.
The commitments to anti-inflationary policies vary in strength, from weak to strong. The weakest of these is considered to be central bank independence. It has been noted that central bankers are not typically dismissed for failing to meet their inflation targets. In fact, keeping monetary policy tight is seen to present a greater career risk, a lesson that has reportedly been learned by Federal Reserve Chair Jay Powell. Although the U.S. central bank is considered to be independent of the executive branch in a notional sense, President Donald Trump has expressed a desire for easy money and has been publicly criticizing Mr. Powell’s decisions.
This is not a new path for U.S. presidents. Both Presidents Lyndon Johnson and Richard Nixon were known to have pressured their top central bankers to ease policy. At one particularly contentious meeting, President Johnson is said to have pushed Fed Chair William McChesney Martin against a wall. It has been noted that Mr. Martin’s successor, Arthur Burns, failed to stand up to President Nixon and, as a result, is believed to have inadvertently unleashed the “Great Inflation” of the 1970s.
A much stronger commitment to price stability is made by governments that choose to issue inflation-linked bonds. When the United Kingdom first issued government bonds whose principal and interest were tied to the price level in 1981, a Treasury paper opined that indexed borrowing imposes a certain discipline. It was stated that this practice makes it more difficult for a government to use inflation as a way of resolving immediate difficulties, and that only a government that is truly committed to a sustained reduction in inflation would be willing to issue them.
Currently, nearly a third of Britain’s outstanding gilts are “linkers.” It has been a matter of concern that this mountain of indexed borrowing could cause the public finances to crash. It was reported that in June, the government paid just under 11 billion pounds in interest on its index-linked bonds, a figure that was equivalent to 63% of its total debt-servicing costs. Furthermore, the inflation “uplift” on the nominal 423 billion pounds of outstanding linkers has added a considerable 254 billion pounds to the national debt.
However, such fears are likely overstated. The spike in interest costs in June has been described as anomalous. Over the past couple of years, inflation-linked gilts have been responsible for approximately 30% of the total debt-servicing costs, which is in line with their share of the public debt. Additionally, it has been noted that most of the outstanding inflation-linked debt carries very low coupons. As an example, the 2073 index-linked bond was issued with a coupon of a mere 0.125%.
If inflation were to pick up again, the British government would have several options at its disposal to limit the costs. For instance, the government could make adjustments to the inflation numbers that are used to calculate the payments. It has already taken a step in this direction. Since 1981, UK inflation-linked gilts have been tied to changes in the Retail Prices Index. However, it has been announced that beginning in 2030, the payments will be linked to a different price benchmark known as CPIH. This index has historically produced a lower inflation reading. It has been estimated by the Office for Budget Responsibility that this change will result in savings for the government of approximately 4 billion pounds in 2030 alone. This move demonstrates a long-term strategy to manage the costs of its indexed debt in a proactive manner. The ongoing debate over how governments will manage their debt burdens in a world of low growth and political aversion to austerity remains a central theme for economists and policymakers.
