Where the Gilt market goes in coming months is going to be very important for the UK economy and politics. There is little history of countries being able to sustain deficits of the UK's magnitude, for very long, without serious market problems. At the moment, we're getting by thanks the sticking plaster approach of quantitative easing. The Bank of England has purchased £186bn of gilts so far this year, almost perfectly matching the £179bn the Debt Management Office has needed to sell so far. As long as the Bank is willing to support the market with a fast-rolling printing press, government funding at attractive rates is assured. However, the end of the money printing programme will require the Gilt market to adjust to the rates which market buyers want in return for providing financing to the UK.
The interest rate that the UK taxpayer needs to pay on Gilts has already been rising relative to those of the Eurozone – and this despite the Bank of England maintaining base rates at 0.5 percent below European levels, and printing up to £1 billion a day to purchase Gilts. The graph below shows the result: UK financing costs are now 0.7 percent above those of Germany.
But what will happen when the plug is pulled on quantitative easing? Well, given that no developed nation – with the very unusual exception of Japan – has dared for decades to adopt the printing-press solution to government deficits, there are no clear historic guides to how any adjustment process will work. At the moment, the Bank of England thinks that quantitative easing reduces the interest rate the UK taxpayer pays on Gilts by about 75 basis points, but some leading fund managers think it may actually be closer to 2 percent. Of the three European countries with comparable deficits, Latvia is now in the hands of the IMF, while Ireland and Greece have to pay between 1.5 percent and 2.5 percent more for borrowings than Germany, despite increasingly aggressive austerity measures. If the UK reaches those levels, then the public finances would go into meltdown.
While the Bank has slowed its pace of money printing recently, from £7 billion a week to £3-5billion a week, they will have used up their £200 billion target of new money by mid-January. So Gordon Brown's appointees to the Monetary Policy Committee will face a momentous decision: do they keep financing the government, for a few months more, despite inflation potentially being close to double their target? Or do they let the market set the interest rates on Gilts? Their answer could prove to be one of the most significant factors in the run up to the election.