• Richard Walker

If you wanted to start your journey, I would start from anywhere but here...


Summary

  • Debt to GDP levels have risen to historically high levels in many countries

  • The UK, much like others in the G7, has borrowed in the wake of the Great Financial Crisis and the Covid-19 pandemic.

  • Lockdowns implemented to slow the spread of the virus left products in warehouses and service sector workers sent home

  • At the same time there was an unprecedented stimulus in demand with low rates, asset purchases, cheap credit and government furlough schemes

  • Inflation results from too much money chasing too few goods and services

  • This has been further exacerbated by the war in Ukraine leading to rising food and energy prices

  • To tame inflation central banks seek to raise rates and reverse asset purchases

  • Losses from the UK’s asset purchase facility are borne by the UK Treasury. If got prices are surpassed by accelerated asset sales or additional gilt issuance then further strain will be place on the UK’s finances.

A very knotty British problem...

In this blog we attempt to frame the amount of manoeuvre that a future UK Prime Minister has for cutting taxes. In so doing we uncover a pernicious feedback loop between taxation and public finances.


Namely:

  • If tax cuts stoke inflation, this will put further pressure on the Bank to accelerate gilt sales.

  • Gilts bought by the Bank of England are underwritten by the UK Treasury.

  • This means that if gilt prices fall as a result of accelerated asset sales then this will further deplete the UK's finances.


UK Fiscal policy redux

In a previous post we looked at the UK’s Finances through the lens of Fiscal policy. Unsurprisingly we stated that the UK’s fiscal room for manoeuvre appears limited. Debt to GDP is running at historic highs. Accordingly UK’s debt interest payments have risen more than threefold since the Great Financial crisis from just under £2B a month in 2007 to more than £6.3Bn a month today.

Figure 1. UK Debt to GDP

A further wrinkle is that a large amount of UK gilts are index linked. They are linked to UK RPI which is currently running at 13.2% according to the ONS This further increases the debt servicing obligation on the UK.

UK Monetary policy

From a monetary policy perspective inflation has been running well above the Bank of England’s 2% target for some time. The Governor of the Bank of England and the UK’s previous chancellor of the exchequer have both signalled an end to asset purchases.


The consequences of short term rate hikes to counter inflation, increased government borrowing and gilt sales from the APF would like expected to lead to both a sharp rising and steepening of the UK yield curve.

In this blog we’ll look at some historic data for the bank of England’s balance sheet as well as UK inflation data to provide some context for policy decisions and forecasts.

Bank of England Balance Sheet

The two figures below show the huge increase in the Bank of England’s balance sheet in the last decade and a half. This first chart shows the absolute value of the balance sheet.

Figure 2. The increase in the Bank of England Balance Sheet since 1966

While the chart below shows the Bank of England Balance sheet in relation to GDP.


Figure 3. The BoE's balance sheet as a percentage of UK GDP

The latest BoE balance sheet was published last week on 5th July. The single largest asset is the loan taken out to fund the APF. This sits on the asset side and is shown as £794Bn.

Figure 5. Bank of England Balance sheet published 31 March 2022. Source: Bank of England

The value of the APF is part of ‘Reserves balances’ which shown as a liability of £794Bn. The Bank of England is indemnified by the UK Treasury for any losses in the APF - so there is currently an additional £4Bn of liabilities to be picked up by UK Taxpayers. Clearly this value may increase or decrease.

Bank of England Inflation Target.

The chart below shows the Bank of England’s chosen Inflation a target - CPI. Since 1991 this has stayed within or close to the 2% target. Notable deviations can be seen around the time off the Great Financial Crisis, the Sovereign Debt Crisis and around 2015 with the slump in energy prices.


Figure 5. The BoE's chosen inflation target - CPI in orange, shown with the corresponding BoE policy rate in green

It can be seen that recently that inflation has spiked. This has resulted in the Bank of England raising rates - it currently appears less hawkish than the Fed, but not as dovish as the ECB.

How does this play out?

It is hard to see the Bank of England not following through on commitments to raise rates. It’s principal remit is price stability and all measures of inflation are running high, including its target policy rate. To further control rates it is also hard to argue against further quantitative tightening and running down the stock of gilts (plus very limited amount of corporate bonds) bought under the asset purchase facility. Morgan Stanley estimates that the balance sheets of the BoE, the Fed, the BoJ and ECB will shrink by about $4Trn between now and the end of 2023.


Sales of bonds by central banks accompanied by more issues from governments and increases in short term policy rates will steepen and raise yield curves, In theory this should encourage more saving for the future than borrowing to spend now and over time get inflation under control.


Impact on UK taxes - seemingly the battleground for the conservative leadership

The debate in the leadership election for the conservative party is currently revolving around taxation. Given the current high levels of debt servicing it is hard to see tax cuts in the near term without increased borrowing.

If the UK government finds room for tax cuts - presumably from higher than forecast growth - then this sets up an interesting dynamic between the government and the Bank of England.

Tax cuts put more money in the hands of individuals and businesses, further stoking inflation. This may require the bank to accelerate both policy rate increases and gilt sales. As rates and yields rise, prices fall. The value of the gilts held under the APF will decline. Recall that this loss is underwritten by the UK Treasury and therefore places yet further strain on the UK’s finances.


All this sets up some interesting feedback loops as we attempt to wean ourselves from QE and ultra-loose monetary policy. Tax seems to be the core battleground for the fight for the Conservative party leadership. But given the delicate state of the public finances of the UK and the complex interplay between taxation, debt servicing, government expenditure, inflation and the value of bonds currently held in the APF the correct approach seems far from straightforward.


Boris Johnson may find some solace in the words of the Gaoler to Posthumus Leonatus: Cymbeline, Scene 5 Act 4, “But the comfort is, you shall be called to no more payments, fear no more tavern bills.”

Conclusions:

  • In common with many in the G20 the UK has a high (and rising) debt to GDP ratio

  • Inflation is running high in the UK

  • As an independent Central Bank focussed on price stability the BoE will seek to raise rates and reverse Quantitative Easing

  • The UK Treasury underwrites any losses from the Bank of England’s Asset purchase facility

  • The UK’s governing party is in the middle of a leadership election where the key issue appears to be tax cuts

  • There isn’t a great deal of wiggle-room in the UK for tax cuts

  • Should more wiggle-room be found, for instance through higher productivity or greater than forecast growth a more pernicious problem might arise

  • If those tax cuts prove to be inflationary, which results in faster rate rising and bond selling by the Bank of England then this might increase losses under the Asset Purchase facility which are borne by the UK Taxpayer.


Appendix - Interest rates weren't always this exciting...


The Bank of England, perhaps more than any other central bank, has a long history of excellent record keeping. One can see the BoE policy rate since its formation. If one overlays the rate with significant historical events (I've principally chosen conflicts and advances in communication) one can see that it is not until the very beginnings of mass communications that policy rates moved much at all.


Figure 6. Bank of England Policy rate through the ages.
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