The UK government is spending a huge amount of money on COVID-19, supporting medical services, relieving the suffering of those who have lost their income and helping companies float.
This spending policy is currently approved by the International Monetary Fund. Governments in developed countries should spend more not only keeping their economies in good shape until the pandemic passes, but also investing in preparation for a post-COVID recovery, IMF says.
And you don’t have to worry that this extra spending is causing a huge increase in government debt. The UK debt / GDP ratio is already over 100%, but the government needs to spend more. This stimulates GDP growth and stabilizes debt / GDP.
According to the IMF, the way to deal with high government debt is not austerity, but tax increases and spending cuts, and vice versa, at least during a pandemic.
A key factor in the success of this high-value policy is low interest rates. The UK Government’s 10-year new borrowing cost is currently 0.3%. It wasn’t so cheap. The Bank of England plays an important role in maintaining that.
How do you pay?
To pay all the extra spending, the government usually borrows from the private sector, such as pension funds and insurance companies. It does this by selling bonds that are promised to be repaid in interest. From April 2020 to June 2020, we borrowed an additional £ 150 billion. Still, as soon as the government sells bonds, the Bank of England buys bonds from private sector holders and pays with the newly created money. Technically, this money is a “reserve” deposit, a claim to the Bank of England itself.
Therefore, indirectly, the Bank of England is funding many of the government’s new spending. And, decisively, its ongoing demand for government debt holds back the interest rates that the government has to pay to borrow.
The Bank of England argues that this large-scale quantitative easing (QE) program for bond purchases is not driven by the need to support the government’s finances. Rather, its motivation is to fulfill its mission to curb inflation, which is increasingly below the 2% target for over a year. Both government demand for funds and Bank of England bond purchases were the result of a recession, and it is a coincidence that bond purchases and government sales were in similar proportions.
Read more: Will the Bank of England’s reliance on quantitative easing help the UK economy?
You might think this is tearing the hair, but it’s important. If the government can let the Bank of England buy bonds as needed to prevent rising interest rates, there is no certainty that banks will raise interest rates sufficiently when needed to stop rising inflation.
And the current low-inflation environment may be short-lived.
Inflation can rise
In 2020, personal consumption declined significantly. Among the causes, restrictions on several sectors of the economy, especially tourism and leisure, have forced people to save rather than spend. When regulations are relaxed, stagnant demand can lead to higher prices, especially if the supply of goods and services declines due to the failure of some businesses to survive.
On the other hand, some argue that rising unemployment will push down wages and thus prices, while others expect slow recovery and time to adjust supply. Moreover, as consumption patterns change, price changes vary across sectors, raising questions about the overall impact on inflation.
A deeper reason to expect inflation is proposed in a new book by economists Charles Goodhart and Manoi Pradan. They argue that the current low interest rate and low inflation situation is associated with a favorable dependent ratio. It measures the number of young people and the elderly (0-14 and 65+) compared to the middle-aged people, who are estimated to be in the working population. For the past three decades, we’ve been in the “sweet spot,” they say, and many workers around the world are helping non-workers. This reduced wages, led to higher savings and, in turn, contributed to long-term declines in interest rates.
However, the age structure of the population is changing. Dependency ratios are rising as people live longer and the birth rate declines. There are fewer workers and more people are relying on their achievements. In addition, old people need more and more attention. To balance supply and demand, we need to raise wages and prices.
If inflation begins to rise, the Bank of England’s response should be to curb demand by raising interest rates. But this will slow economic growth, it may still be fragile. It will push down the prices of assets, including property, and make debt repayments, including public and private sector debt, raised by the pandemic more expensive. Under the IMF’s projected increase in government debt to 117% of GDP, even a slight rise in interest rates will make it significantly more difficult to maintain this debt.
The Bank of England is determined not to distract from its 2% inflation target, while other central banks are more ambiguous. In the United States, for example, Jay Powell, chairman of the Federal Reserve Board of Governance, which sets monetary policy, recently announced that future US inflation could exceed its target for a period of time before monetary policy was tightened. did.
Despite the Bank of England’s allegations, its tolerant behavior during the Covid crisis suggests that the Bank of England may also take a more flexible attitude towards future inflation.
Author: John Whittaker-Senior Teaching Fellow, Economics, Lancaster University
UK government COVID spending can lead to inflation
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