Inflation and public finances
Over the period 1946-1990 there was a huge fall in the debt-GDP ratio, from 283 to only 29 percent. Inflation contributed 135 percentage points of this, with an average rate of inflation of over 7 per cent. In contrast, of the other determinants of the debt-GDP ratio, GDP growth reduced the debt–GDP ratio by 50 percentage points and primary surpluses reduced it by another 40 percentage points. Since the financial crisis in 2008, the debt-GDP ratio has increased from 41 to 105 percent in 2020. Over this period inflation has been very low, averaging 2.6 percent from 2008-2019, and so made little contribution to bringing down the debt-GDP ratio. With inflation now over 10 percent and rising, and with the debt-GDP ratio at around 100 percent, inflation is making a 10 percent reduction in the debt-GDP ratio, or roughly £220bn, each year.
This estimate is not, of course, a measure of the total impact of inflation on the debt-GDP ratio. It ignores the increasing cost of debt due to rising interest rates and a government wage bill. Historically, the interest cost of debt has contributed around 4 percent each year to increases the debt-GDP ratio, with little variation. If all debt were rolled over each year, each one percent increase in interest rates would currently add one percent to the debt-GDP ratio and fully offset the effects of inflation. Currently, new issues amount to £150bn, which is about 7 percent of total debt and of GDP. 30 percent of this is short term and needs to be rolled over frequently, while short- and medium-term debt (1-7 years) make up half new issues. Only 18 percent is long-term debt. Each one percent increase in interest rates therefore adds about £1.5bn to annual debt interest payments. Were interest rates to increase one-for-one with inflation as in the past, but not currently, debt interest payments would increase by £15bn.
This brings us to the Bank of England’s monetary policy. Its remit is to keep inflation within one percentage point of 2 percent. It has chosen not to do this, believing that the current level of inflation is temporary. This ignores the danger of second-round effects via attempts to maintain real wages and the impact this has on inflation expectations, a main driver of wages. The policy of using interest rates to control inflation is only suited to inflation that arises from demand shocks, positive or negative. It is not suited to negative supply shocks, such as the energy-price shocks of the 1970s and today, as increasing interest rates to dampen demand only adds to the contractionary effects of the supply shock. Nonetheless, monetary policy should be tightened to avoid these second-round effects. This was a major issue in the much-criticised policy of the Conservative government in in the period 1979-81 when it used both monetary and fiscal policy to contract demand. The problem is that the supply shock is a relative price shock and requires a relative price adjustment which can hit parts of the economy hard and permanently, and it takes time to adjust. The benefit of taking this hit to the economy in the 1980s was nearly twenty years of continuous growth. Unless the Bank of England is correct, and the price shock is temporary, we are in a similar position today. In the meantime, while we wait to find out, inflation is rising, interest rates are far too low to stop inflation expectations and wage claims from increasing, and only government finances are benefiting.
Prof Michael Wickens is a Professor of Economics at Cardiff University, and an Emeritus Professor of Economics at the University of York. He was a Specialist Adviser to the House of Lords Economic Affairs Committee from 1999 to 2016.