In today’s issue:

  • Inflation has turned back up
  • Can interest rates rise without sending governments broke?
  • What happens when they can’t, Japan Edition

It must be getting very awkward over at the Bank of England. Not to mention the Federal Reserve and Bank of Japan. Inflation is ticking back up in a growing list of countries. But can governments afford a higher interest bill?

Yes, central banks are supposed to increase interest rates to rein in inflation. But this also increases the interest rate on government bonds.

In an age when overindebted governments themselves threaten to be the source of the next financial crisis, that’s terrible news. It might send their interest bill soaring out of control.

If inflation continues to rise, central banks will be forced to choose between their mandate and their boss, the government. Will they raise interest rates to rein in inflation and preserve the value of the currency? This would be at the expense of raising the government’s interest bill dangerously high.

Or will central banks prioritise their boss’ financial stability by keeping interest rates low. This would be at the risk of letting inflation soar even higher.

It’s a tough choice.

And the Bank of Japan, for one, has chosen to fund the government at the expense of the currency.

The Japanese central bank recently refused to raise rates above 0.1% despite inflation running hot. Well, hot by Japanese standards. Last year’s 3.1% was the highest level since 1982.

Why is the Bank of Japan keeping interest rates incredibly low even as inflation is above their target?

Well, what do you expect them to do!?

The government’s debt-to-GDP ratio is around 260%. A 1% increase in interest rates would be downright dangerous to the financial stability of the government itself.

The government of Japan can’t afford to pay a sensible interest rate. So the Bank of Japan cannot raise rates to sensible levels.

But as a result of prioritising the government’s finances over the inflation rate, the currency has been smashed. It fell almost 2% against the US dollar on Friday. And over the past few years it has crashed.

This is big news. Even my wife’s financially illiterate friends here in Japan heard about it. Heck, they even talked about it at a barbeque before I got the chance to ask.

What does Japan mean for you?

Japan is the extreme example that proves the point I’m trying to make. But the UK, US and many others face the same type of problem.

Government debt is so high that central banks may not be able to raise interest rates enough to bring down inflation. Not without adding a dangerously high interest bill to the political debate. And Liz Truss can tell you all about how this can play out.

Indeed, the interest bill is already a key part of the political discourse in the US and UK. Interest is crowding out other spending from government budgets. Presidential contender Donald Trump is even suggesting the Fed’s independence may be under the microscope. This after the Congressional Budget Office head warned about a Liz Truss type moment if Trump is elected.

But let’s take a closer look at the mechanics.

How it works

Consider a highly simplified example to make the point. The UK’s government debt to GDP is around 100%. The government owes as much as the entire country produces in a year. Interest rates are at 5.25%.

Now, do the maths…

If the government has to pay 5.25% interest on a debt valued at 100% of GDP, while that GDP grows at say 5%, then the interest bill is growing faster than the economy. The debt-to-GDP ratio would be rising over time from interest alone, let alone the budget deficit.

For the debt-to-GDP ratio to fall, the interest rate would have to be below the pace of economic growth.

So, do you think the UK economy can grow at more than 5.25% a year on a balanced budget? Or even more, if the Bank of England raises rates further?

That’s a trick question. Because the UK economy is barely growing at all by one measure. And yet roaring along by another measure.

The UK’s real GDP growth is around 0.1% in 2023. But nominal GDP growth was far more last year. That’s because nominal GDP growth includes inflation. Higher prices mean more economic activity… if you measure it in terms of pounds.

The UK’s nominal GDP growth fell from over 8% at the start of 2023 to under 5% in the final quarter. This is crucial because it suggests nominal GDP is now growing slower than interest rates are increasing the debt pile. In our simplified example, our debt to GDP would be rising.

But there are some additional factors to consider. Our example was simplified, after all.

How it really works

Firstly, the government borrows at market rates, not the Bank of England’s interest rate. And bond yields can be above or below the BoE’s rate. That’s because the debt is borrowed for many years and interest rates could rise or fall during that time.

Secondly, the government usually borrows on a fixed interest rate. While interest rates may well have surged, the interest the government pays on some of its debt remains at pandemic lows because some of it was borrowed during the pandemic.

We can deduce a lot from these factors.

Firstly, any inflation shock directly benefits the government. The government borrowed money on the cheap at fixed interest rates. By the time it has to pay it all back, it’ll be worth less.

Secondly, higher interest rates take a long time to filter through to the government budget. It’s only when old debt matures and needs to be repaid that the higher interest rates begin to matter. That’s because the government tends to borrow more money to repay the old loans. At this point, like refinancing a mortgage, the higher rate hits home.

Thirdly, just as an increase in inflation and interest rates benefits the government thanks to its fixed rate debut, a drop in inflation and interest rates does not benefit the government. It would be left having borrowed at high rates of interest, despite the subsequent fall. It is not in the interests of the government, or its debt situation, for inflation or rates to come down.

The key issue is one of timing. Economists call it “duration”. A government that borrowed for long periods of time will be somewhat immune to changes in interest rates for long periods. The interest bill on a 30-year bond will remain fixed for that long.

A government that borrows for short periods of time will see changes in interest rates impact the budget more quickly.

All governments borrow for a variety of terms. You can find anything from four weeks to 100 years. But the average borrowing varies significantly from one country to another. Thus, different governments face different exposures to interest rates.

In coming months, it’ll be these considerations and factors that determine which governments and currencies go the way of the Japanese, Liz Truss or Greece in 2012.

It’ll be like a reality TV show. We hope you enjoy it…

Until next time,

Nick Hubble
Editor, Fortune & Freedom