The Bond Market Crisis Has Been Exaggerated

There has been much wringing of hands about the recent increase in the UK government’s borrowing costs. This obviously matters as it will constrain fiscal policy, but the increase in long-term interest rates is not unexpected and it does not necessarily represent a loss of confidence in the government. What matters is identifying the underlying cause of the increase in borrowing costs. And to manage economic shocks better, we urgently need to rewrite the fiscal rule.

Once again, money markets are going through one of their periodic panics. They need to take a chill pill. While borrowing costs have palpably increased, the movement in long-term rates represents an international shift in long-term bond prices – it is simply not unique to the UK. In short, world nominal rates are normalising, at last.

The Bank of England’s monetary policy committee’s choice of Bank rate is the main determinant of long-term interest rates in the UK, albeit with an extra factor that depends on the expected path of the Bank rate. For example, it took eight years after the global financial crisis of 2007–09 for the UK’s 10-year gilt rate to fall beneath 1% because markets expected interest rates to return to their long-run norm of 4–5%.

The current increase in borrowing costs does not in any substantive way resemble what happened after the mini-Budget in the autumn of 2022, orchestrated by then prime minister Liz Truss and chancellor Kwasi Kwarteng. Looking at the gilt rate alone does not explain market turmoil. The adjustment in bond prices in 2022 was abrupt, damaged money markets and was the result of a renegade “special fiscal operation”. This time we have mostly had an orderly adjustment, which ought to allow market participants time and liquidity to adjust their positions. I suspect market participants have been caught off-guard by getting their policy rate forecasts wrong.

There are two matters to which we should pay close attention. First, the term or risk premium that markets require for holding long-term debt. The risk premium shot up under Truss because there was no co-ordinated agreement between the Treasury, the Office for Budget Responsibility and the market about the quantity of debt the government was seeking to sell. Back then, the risk premium rose to over 70 basis points. The premium today is entirely consistent with long-run norms at around 20bp.

Second, what matters for determining the policy response is the shock or driver for the increase in borrowing costs. If it is not because of errors in policy, then we may not need to change policy. If it were the result of an expected boom in productivity it would certainly not require tighter fiscal policy. We have not identified a shock that requires a fiscal contraction. In this case, the increase in borrowing costs is probably not much of a shock. And the noise we hear echoing around markets and media is more the result of a fiscal rule that must now be abandoned.

Sidney Webb has been reported as saying when the UK left the gold standard in 1931 that “no-one said we could do that”. And here we go again. In previous episodes – 1931 (leaving the gold standard), 1967 (devaluation of sterling), 1976 (the International Monetary Fund rescue) and 1992 (exit from the EU’s exchange rate mechanism) – we eventually abandoned a rule when it no longer became tenable. In each case it was against overwhelming strength of support for the status quo. Ultimately in each case, we benefited hugely from the exit from the rule.

We are on the same track today. The straitjacket of an inviolable fiscal rule helps us not one jot. A rule of thumb is helpful, but it should be a guide rather than a god. What we need to do is to build in flexibility that is clearly understood by policy-makers, market participants and the media. Fiscal solvency is critical, but if we design wriggle room that deals with shocks, and demand that the chancellor provides a plan and timeline for the correction, fiscal policy will actually improve and become more stable.

This article first appeared on Central Banking on 13 January 2025 and is reproduced here with their kind permission.