A tale of two, two trillions

In recent weeks, two events have made the news because a valuation has reached the ‘magic’ number of two trillion. These were the market value of Apple, and the amount of the UK government’s debt. In themselves these are quite astonishing (and incomprehensible) numbers.

However, concerns have been expressed that the inevitable outcome of such a massive spike in government borrowing will be inflation. So far that has not been the case. Indeed, the latest data (September 2020) showed a sharp drop in the rate of price inflation.

A speech at the London School of Economics on 2^nd September 2020 by Ben Broadbent, Deputy Governor of the Bank of England, provided some clues about why fears of inflation may be ill founded.

A parallel is sometimes drawn between policy responses to the Covid-19 pandemic and wartime measures. In WW1 and WW2, government borrowing rose significantly, and retail price inflation followed. Why? In wartime, governments borrow in order to spend on actual goods and services for the war effort. As Mr Broadbent said:

“It buys more stuff and employs more people. All else equal, this is inflationary. It often requires real interest rates to rise, in order to “crowd out” spending by the private sector and its demand for those same resources"

In the present crisis, government is not spending materially more on buying stuff: it is forced to borrow because tax receipts have fallen sharply and because government has compensated people for (some of) the impact of mandatory lockdowns.

In consequence of the lockdowns, demand in the economy has fallen sharply, well below the capacity of the economy. As a result, unemployment and spare capacity are rising. These are significant brakes on inflation, and the global response of central banks has therefore been a further easing of monetary policy by reducing interest rates and undertaking more quantitative easing (QE).

Mr Broadbent also pointed out that QE is effectively a ‘maturity swap’, i.e. the longer-term liability of government to pay interest on bonds is replaced with another short-term version of the same. This materially reduces the scope for government to deliberately target higher inflation in order to erode the real value of its debt liabilities.

QE on a large scale was first seen in response to the financial crisis of 2008-09. For the reasons set out by Mr Broadbent, despite this, and the easing in monetary policy that occurred whilst government debt was rising, inflation either remained close to target, or below it.

So far, the financial markets have maintained faith in the credibility of the Bank of England’s response – market expectations of inflation have remained stable.

Investors can therefore take some comfort that inflation is not a ‘stealth tax’ on their capital; however, we all need to continue getting used to ultra-low interest rates. These are now biting widely: for example NS&I has announced a reduction in the rate on its very popular Income Bonds from 1.16% to 0.01% (AER gross) from 24^th November 2020.