Let inflation rise or raise rates – the brutal choice facing central banks
He is right. Once upon a time, the role of the central bank was to reduce inflation, nothing more, nothing less. But now, apparently, it’s about building a better world for everyone. So, hand in hand with governments, they have become in financing the deficits linked to Covid that it may no longer be possible to increase interest rates significantly without causing a budget crisis.
The crux of the matter is well explained by the Office for Budget Responsibility in its latest Economic and Fiscal Outlook. “Since 2009, the Bank has acquired through its Asset Purchase Facility (APF) around a third of the total stock of UK government bonds (gilts) with a median maturity of eight years and an average interest rate 2.1 pc “, observed the OBR. âHe financed these purchases by creating his own commitments in the form of central bank reserves which, essentially, carry an overnight interest rate, the Bank Rate, which is currently 0.1 pc.
âThe net result was an interest rate saving for the public sector as a whole of Â£ 17.8 billion in 2021-22 thanks to the difference between the rates on the gilts and the discount rate. But these savings have also come at the cost of a significant reduction in the median maturity of the outstanding gilts from 11 years to less than four years â.
The result is that not only has the asset purchase program significantly weakened the once admirably robust profile of national debt, it has made that debt very sensitive to any changes in short-term interest rates. And that goes for the economy as a whole, which is much more in debt than before.
If you get an interest rate of just 0.1 pc, the effect on large debtors such as governments of a 3 pc increase would be enormously more destructive than an increase of an order of magnitude similar to the late 1980s and early 1990s, when rates were already in double digits.
Central banks face a brutal choice; allow inflation to rise or raise interest rates in a way that causes a fiscal and economic crisis. No prizes for guessing in which direction they will go.