Gilt Yields, Fiscal and Political Uncertainty: What's Driving UK Borrowing Costs?

A large majority of panellists thought that rising gilt yields in April and May reflected higher political and fiscal policy uncertainty. Some 83 per cent of the panel either agreed or strongly agreed that political and fiscal uncertainty drove up gilt yields. Other panellists attributed the rise to the UK’s vulnerability to the latest energy shock.
The panel thought that a more credible medium-term fiscal consolidation plan would help to bring borrowing costs down. One third thought that a more credible plan would be “very effective” in this endeavour and half thought it “somewhat effective”. Several noted that this effectiveness depended on whether fiscal consolidation was accompanied by a credible growth strategy.
The panel was mixed on whether pausing the Bank of England’s Quantitative Tightening (QT) program would lower borrowing costs. Roughly two-fifths of respondents thought a pause would be “somewhat” effective, while another two-fifths deemed it “not very” effective. The rest of the panel was split between fifteen per cent who thought it would not be effective at all, and five per cent who believed it would be very effective.

Question 1: UK long-term gilt yields have been volatile of late, having increased substantially through April and mid-May. To what extent do you agree that this episode reflects a higher UK risk premium associated with political and fiscal policy uncertainty?

All questions in this survey received twenty-four responses.

Roughly one-third of panellists selected “strongly agree” when asked if the rise in long-term yields reflected political uncertainty, while around half chose “agree”. Three panellists opted for “neither agree nor disagree”, and one panellist selected “disagree”. No panellists chose “strongly disagree”.

Panellists who agreed that rising gilts reflected political uncertainty pointed towards the timing of the increase and the prospect of looser fiscal constraints under a new Labour premiership. Matthias Doepke (LSE) summarised this perspective: “[It is] quite clear from the timing and market voices that this relates to the rise in political uncertainty following local elections, especially considering the possibility that Labour will turn further left and soften on fiscal targets.”

Several panellists recognised a larger role for the latest energy price shock. Charles Bean (LSE) argued: “While the majority of the rise in UK bond yields is likely to have reflected global factors, notably the conflict in the Gulf, the rise in UK yields relative to those in peers such as Germany and the US is likely to reflect a combination of (i) a market perception of greater inflation persistence here, reflected in higher expected short-term interest rates; and (ii) concerns about political/fiscal instability at the long end of the yield curve associated with a higher risk premium.” James Smith (Resolution Foundation) commented: “Fiscal risk premia has played a role but the main driver of yields over this period has been the oil price. This has been poorly understood and occasionally misrepresented in the public discourse.”

Question 2: How effective would each of the following be in reducing UK long-term gilt yields?

The panel thought that a more credible medium-term fiscal consolidation plan would help to bring borrowing costs down. One-third of panellists thought a more credible plan would be “very effective” in lowering borrowing costs. Half of the panel thought it would be “somewhat effective” and around a fifth opted for “not very effective”. No panellists voted for “not effective at all” or “counterproductive”.

A number of panellists argued that fiscal consolidation should be accompanied a growth strategy. John Muellbauer (University of Oxford) argued: “The success of fiscal consolidation would depend very much on its nature. If combined with a credible growth strategy, a restructured tax system shifting the balance away from taxes that disincentivises mobility, work and innovation could bring down yields.” In a similar vein, Lukasz Rachel (UCL) commented: “By credible consolidation plan I mean a political consensus in which all the main political forces would recognize the constraints the country must operate within, while also carving out space for growth promoting policies.”

Panellists generally deemed measures to reduce household energy bills to either have no effect on or exacerbate borrowing costs. One-third of the panel thought that these measures would be “counterproductive” and another third considered them “not effective at all” in lowering long-term gilt yields. Ethan Ilzetzki (LSE) argued: “I think that the UK can and should take measures reduce UK vulnerability to energy cost fluctuations. But this is a medium-term challenge. Further, vulnerable households should be supported and protected. Clumsy attempts to shelter households from energy prices in the short run does little to solve the structural problem.”

The panel was mixed on whether pausing the Bank of England’s Quantitative Tightening (QT) program would lower borrowing costs. Roughly two-fifths of respondents thought a pause to QT would be “somewhat” effective, while another two-fifths deemed it “not very” effective. The rest of the panel was split between three respondents who thought it would not be effective at all, and one panellist who believed it would be very effective.

Arguing against pausing QT, Costas Milas (University of Liverpool) commented: “It would be wrong for analysts/commentators/experts to call for a QT halt for two reasons. First, the BoE would then be accused of interfering with political issues. Second, abandoning (albeit temporarily) QT, would add further to inflation pressures at the very time the BoE is trying to find a way of dealing with these.”

Panellists thought that shifting to short-dated gilts would not be very effective in bringing down borrowing costs. Half of the panel thought this measure would be “not very effective” and one fifth thought it “not effective at all”. There was more support for exempting gilts from the bank leverage ratio requirement. Two-fifths of the panel thought this would be “somewhat effective” towards reducing borrowing costs. That said, roughly one-third of panellists thought it “not very effective” and thirteen per cent believed it “not effective at all”.

Ricardo Reis (LSE) argued: “Shifting issuance to short-maturity gilts could alleviate pressure on long-term gilts for a little bit, but it would raise fears of a roll-over crisis and ultimately be counterproductive… Financial repression through changes in bank regulation can be quite effective on rates, but it is not a replacement for a growth and fiscal plan”. Similarly emphasising the importance of fiscal strategy, Stephen Millard (NIESR) commented: “Pausing the Bank's QT programme and shifting towards the issuance of short-maturity gilts will help as both policies will act to make long-term gilts scarcer relative to short-term gilts, but these effects are likely to be small relative to the overall problems of high debt and political uncertainty.”

To access the full panel responses, including the free text comments where respondents expanded on their answers, please download this MS Excel sheet.