- Higher inflation is improving the government debt picture as nominal GDP outgrows the debt stock
- But in the longer term, it could mean periods of negative real returns for bondholders
There are few upsides to high inflation. With UK CPI still at 10.7 per cent, households are enduring soaring prices and falling real wages while investors struggle to protect their portfolios against inflation. But it’s not all bad news. In the short term, at least, higher inflation is driving a reduction in global debt ratios.
According to December research from the IMF, public sector debt in advanced economies fell by 5 per cent of GDP in 2021, with the impact of high inflation shaving off between 1.5 and 3 percentage points.
Higher inflation usually means rising nominal GDP, meaning that debt as a proportion of GDP starts to look like a more favourable figure. Then there is the impact of fiscal drag – something that UK taxpayers know only too well. As taxes are calculated based on nominal incomes, revenues tend to mechanically improve with GDP growth. A cross-country analysis from the IMF suggests that an unanticipated increase in the annual inflation rate of 1 percentage point could increase tax revenues by 0.3 per cent in advanced economies.
But as silver linings go, it’s a pretty meagre one. Firstly, this mechanism only works as long as inflation is a ‘surprise’. As the chart shows, the level and persistence of inflation we endured last year took even the Bank of England by surprise. But over the longer term, reality soon starts to bite. Higher inflation leads to higher government spending thanks to inflation-linked obligations (think state pension and working age benefits in the UK) as well as higher pay demands.
The cost of servicing debt also starts to rise if investors demand a higher inflation premium to lend to governments. The IMF report euphemistically explains that “recent developments in bond markets” highlighted “investors’ heightened sensitivity to deteriorating macroeconomic fundamentals and limited fiscal buffers”. They warn that in times of turbulence and turmoil, confidence in long-run stability is a precious asset – something that Liz Truss found to her peril.
The evidence also suggests that the impact of higher interest rates varies depending on the public debt profile of each economy, with quantitative easing increasing vulnerability to interest rate rises. What’s more, inflation has a limited ability to whittle away at government debt in the UK because of the sheer amount held as index-linked gilts. ONS figures reveal that the interest payable on central government debt in November was £7.3bn – with £4.3bn of this reflecting the impact of higher inflation on the interest payable on index-linked gilts. High inflation can quickly translate to rising government borrowing costs.
UBS analysts argue that the main surprise of 2022 has been the persistence and level of inflation, which boosted nominal GDP, allowing it to outgrow government debt stocks. But improving debt sustainability hasn’t been positive for fixed-income investors: high inflation has led to large interest rate hikes, resulting in poor returns for bonds.
UBS analysts believe that rates are currently in the process of peaking. This means that bonds should be an attractive ‘tactical’ investment for the next 12 months if prices rise and yields start to retreat once interest rate cuts appear on the horizon. But over the longer term, they are more cautious, seeing a possibility that persistent inflation and low rates combine to leave bondholders facing negative real rates.
UBS analysts also challenge the narrative that improving debt sustainability is good news for fixed income investors: after all, the debt of one entity is the asset of another. A period of negative real rates may well improve sustainability by eroding the real value of government debt. But it would “essentially have the same effect of destroying wealth” for bondholders, too.
