As inflation becomes more persistent across developed nations, inflation-linked debt becomes particularly costly for governments, even as nominal borrowing costs rise. A dramatic example of this can be seen with the UK, which pioneered this form of borrowing in the 1980s, and is struggling to restore fiscal credibility after its abortive mini-budget in September.
The UK’s Office of National Statistics flagged the rising cost of linkers back in May, noting that index-linked gilts accounted for £40 billion of the UK’s £75 billion annual interest payment bill – an outsized contribution considering that linkers are 25% of outstanding gilts. Meanwhile the US is set to pay $150 billion in interest this year on its portfolio of Treasury Inflation-Protected Securities (TIPS), half the interest bill on nominal treasury bonds, according to the US Treasury website. This is even more remarkable, given that just 9% of US government bonds are TIPS.
These costs are set to rise further, based on market inflation expectations. Using a new visualisation tool created for this purpose, we estimate that for the £2 trillion of UK gilts, annual interest costs are set to rise to £110 billion per year in 2024, and stay at around £100 billion annually for a decade. That’s double UK government forecasts, and doesn’t take into account any additional borrowing.
Data source: Markit iBoxx
With the UK government about to make difficult decisions about spending and taxation, debt interest becomes more important since in contributes to deficits. Why are inflation-linked bonds proving so expensive?