Inflation and Interest Rates since 1900
From one perspective, it is curious that with inflation of 5%, investors are very willing to buy UK bonds pushing interest rates down to 2.2% on 10 year bonds (Nov, 2011). What this means is that investors prefer to hold bonds with a negative real interest rate rather than use their funds to invest in other areas.
The good news for the UK is that with inflation of 5%, we are effectively 'inflating' away part of our debt. With inflation it is much easier to reduce your debt to GDP ratio.
Simple Example Showing Affect of Inflation on Debt.
- Suppose government borrow £1,000bn and nominal GDP is £1,000bn.
- Supposed tax revenues = £400bn (40% of GDP)
- The debt to GDP ratio is 100%.
- Suppose then we have inflation of 100%, and the level of former debt stays at £1,000bn.
- Because of inflation, nominal GDP increases to £2,000bn.
- The debt to GDP ratio will fall to 50%
- Also, if tax rates stay the same, tax revenue will increase to £800bn, making it easier to meet debt interest payments.
But, for the government and borrowers, it is a 'lucky' event which makes the task of debt reduction easier. However, if a country gains a reputation for having 'unexpected inflation' it will become more difficult to sell future debt. It means in the future bond investors will demand higher interest rates to compensate for risk. - There are only so many times you can get away with 'inflating away your debt'
Usually, the threat of inflation would push up bond yields as investors don't want to have this kind of negative interest rate. However, at the moment, pension funds don't want to invest in the stock market or invest in long term capital investment. They only want the security of government bonds. Therefore, in the current liquidity trap, the government can take advantage of borrowing at low interest rates.
Also, part of the reason that investors are willing to buy bonds at such low interest rates, is that they really do expect inflation to fall next year. The current inflation of 5% in 2011 is due to temporary factors such as higher taxes and impact of devaluation. Because markets expect inflation to fall next year, they are more willing to hold UK bonds.
Also, markets fear UK growth will be very low. This risk of a second recession means that the stock market and other investments are still unattractive. Pension funds would rather have the security of bonds rather than risk putting money elsewhere.
Bond yields have also benefited from
- The governments stringent spending cuts.
- UK yields have also been helped by having a lender of last resort (unlike Italy).
Inflation Unfair on SaversInflation invariably reduces real wealth of savers. Many pressure groups representing savers argue for immediate action to protect the value of their savings i.e. higher interest rates to reduce inflation and increase real interest rates.
However, the government and Central Bank have to weigh up the different costs.
It is unfortunate the middle classes see a small fall in the value of their savings. However, arguably it would be a much bigger cost to society, if higher interest rates pushed economy back into recession and a significant rise in unemployment.
Low interest rates reduce living standards, but it is not comparable to the reduction in living standards from unemployment and a prolonged recession.
Savers Also need Economic GrowthSavers are getting such a poor deal because of feeble prospects over economic growth. If the economy recovered with strong economic growth, pension funds would have the confidence to invest in shares and capital investment. They wouldn't feel tied to buying bonds with negative real interest rates.
Therefore, although it is unfortunate savers have negative real interest rates, it is definitely not in their interest to have a sudden rise in interest rates which pushes the economy back into recession.