The World Tied $3.5 Trillion-Plus of Debt to Inflation. The Costs Are Now Adding Up.
With roughly $770 billion of borrowings linked to retail prices, Britain is feeling the pinch
With roughly $770 billion of borrowings linked to retail prices, Britain is feeling the pinch
Governments and companies around the world spent decades loading up on trillions of dollars of debt whose interest costs rise and fall alongside inflation. But what served as cheap funding when prices were stagnant has rapidly become more expensive.
The inflation-linked headache echoes the broader challenges arising at the end of more than a decade of global easy money, in which debtors borrowed vast amounts at very low, and sometimes negative, interest rates. Investors are on alert for financial vulnerabilities after a crisis in U.S. regional banks this year, and with strains emerging in commercial property.
Borrowing costs of all sorts have risen sharply for governments, businesses and consumers, as central banks have raised key interest rates to combat price pressures. Rates have surged on inflation-linked borrowings, but these aren’t the only source of pain.
As standard bonds with fixed rates mature, they need to be replaced with more expensive new debt. Meanwhile, interest rates on loans are often floating, meaning they quickly reflect changes in policy rates.
Yields on benchmark 10-year fixed-rate bonds, a proxy for government borrowing costs, have climbed to about 4.3% for the U.K. and 3.9% for the U.S. Both were below 1% during the pandemic.
Governments will pay roughly $2.2 trillion in overall debt interest this year, Fitch Ratings estimates. The U.S. Treasury’s interest cost grew 25% to $652 billion in the nine months through June. Germany’s debt-servicing bill is expected to soar to 30 billion euros this year, or some $33.2 billion, from €4 billion in 2021.
Governments had $3.5 trillion in outstanding inflation-linked debt at the end of 2022, according to the Bank for International Settlements, equivalent to about 11% of their total borrowings.
The poster child for the inflation-linked problem is Britain, which has experienced the fastest rise in debt costs in the Group of Seven advanced democracies. The U.K. first embraced such debt under Prime Minister Margaret Thatcher and in 1981 became one of the first developed economies to issue inflation-linked debt: securities that are known as linkers there and Treasury Inflation-Protected Securities, or TIPS, in the U.S. Both the amount due to investors once the bonds mature and the regular interest payments they receive move with inflation.
About a quarter of U.K. debt is now tied to inflation, trailing only a handful of emerging markets with a history of runaway prices such as Uruguay, Brazil and Chile.
“We stick out like a sore thumb,” said Sanjay Raja, chief U.K. economist at Deutsche Bank.
The U.K.’s debt woes are complicated by its longstanding reliance on a measure of price increases that has fallen out of favour: the retail price index, or RPI. Some 600 billion pounds, equivalent to roughly $770 billion, of bonds are linked to this gauge, which has consistently risen faster than more widely used consumer-price indexes. London has pledged to phase out RPI by 2030.
Inflation as measured by the RPI topped 14% in October and was still 11% in June compared with a year earlier. Economists expect U.K. inflation to keep falling this year, albeit more slowly than in other major economies.
In theory, higher interest payouts should be balanced by rising revenue. While higher inflation means bigger payouts to bondholders, it should also bring in more taxes.
That logic holds especially true in markets like the U.K., where inflation gauges are deeply embedded in the economy. Tax thresholds, pension and welfare payments, rail fares and cellphone bills are often linked to price indexes.
But the energy shock that fuelled recent inflation upended that math, since higher energy bills drove up RPI even as earnings and consumer spending lagged behind. The U.K. is experiencing the “wrong sort of inflation,” the U.K.’s Office for Budget Responsibility said this month. The sensitivity of U.K. debt to inflation was unprecedented, the watchdog said.
The U.K.’s debt sustainability is a focus for investors after a market meltdown last fall, triggered by then-Prime Minister Liz Truss’s tax-cutting plans.
Her successor Rishi Sunak and his Chancellor Jeremy Hunt have sought to restore market confidence with pledges to contain inflation and bring down debt. As the U.K.’s interest costs climb, and with debt now surpassing 100% of gross domestic product, those promises are getting harder to keep while maintaining investor confidence.
The debt burden also undermines Sunak’s hopes to woo voters and revive the economy with tax cuts and spending measures ahead of a general election expected to take place next year.
“We could quickly be in a situation where we’re facing some renewed sense of crisis, particularly with an economic backdrop of stagflation with really weak growth and overshooting inflation,” said Mark Dowding, chief investment officer at RBC BlueBay Asset Management in London. “Further policy missteps could easily be punished by the market.”
Higher bond yields and stickier inflation will add an extra £30 billion to the U.K.’s annual government debt bill, estimates Bank of America economist Robert Wood.
“The government has three options: You can plan for weaker spending, you could raise taxes or you could borrow more,” he said. “Certainly one could say that this rise in debt-interest costs is incompatible with cutting taxes.”
The U.K. is selling fewer linkers, which are likely to make up 11% of bond issuance this fiscal year, down from above 20% throughout the 2010s.
One veteran U.K. central banker said linkers had largely done their job as envisioned in the 1980s.
“We were coming out of a decade in which inflation had been extremely high. People were very skeptical about the ability of any government, particularly the Conservative government, to bring inflation down to a low and stable rate,” said Charles Goodhart, who was an adviser at the Bank of England between 1969 and 1985.
Fears that linkers would lead to fresh wage-price spirals as unions demanded inflation-linked increases, didn’t play out, he said. Thatcher, who called inflation “the destroyer of all,” saw linkers as “sleeping policemen,” ensuring the government wasn’t tempted to let inflation run to help inflate debt away.
“It makes the current fiscal position more difficult. But that’s what Mrs. Thatcher actually wanted,” said Goodhart. “She wanted governments to resist inflation more strongly.”
Companies are also feeling the pressure from inflation-linked borrowing. The U.K.’s largest water company, Thames Water, nearly collapsed in recent weeks as investors questioned its ability to repay £14 billion in debt, about half of which is linked to inflation. Thames Water’s debt is RPI-linked, but customer prices now track CPI, which lags behind the RPI by about 3 percentage points more slowly.
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Office owners are struggling with near record-high vacancy rates
First, the good news for office landlords: A post-Labor Day bump nudged return-to-office rates in mid-September to their highest level since the onset of the pandemic.
Now the bad: Office attendance in big cities is still barely half of what it was in 2019, and company get-tough measures are proving largely ineffective at boosting that rate much higher.
Indeed, a number of forces—from the prospect of more Covid-19 cases in the fall to a weakening economy—could push the return rate into reverse, property owners and city officials say.
More than before, chief executives at blue-chip companies are stepping up efforts to fill their workspace. Facebook parent Meta Platforms, Amazon and JPMorgan Chase are among the companies that have recently vowed to get tougher on employees who don’t show up. In August, Meta told employees they could face disciplinary action if they regularly violate new workplace rules.
But these actions haven’t yet moved the national return rate needle much, and a majority of companies remain content to allow employees to work at least part-time remotely despite the tough talk.
Most employees go into offices during the middle of the week, but floors are sparsely populated on Mondays and Fridays. In Chicago, some September days had a return rate of over 66%. But it was below 30% on Fridays. In New York, it ranges from about 25% to 65%, according to Kastle Systems, which tracks security-card swipes.
Overall, the average return rate in the 10 U.S. cities tracked by Kastle Systems matched the recent high of 50.4% of 2019 levels for the week ended Sept. 20, though it slid a little below half the following week.
The disappointing return rates are another blow to office owners who are struggling with vacancy rates near record highs. The national office average vacancy rose to 19.2% last quarter, just below the historical peak of 19.3% in 1991, according to Moody’s Analytics preliminary third-quarter data.
Business leaders in New York, Detroit, Seattle, Atlanta and Houston interviewed by The Wall Street Journal said they have seen only slight improvements in sidewalk activity and attendance in office buildings since Labor Day.
“It feels a little fuller but at the margins,” said Sandy Baruah, chief executive of the Detroit Regional Chamber, a business group.
Lax enforcement of return-to-office rules is one reason employees feel they can still work from home. At a roundtable business discussion in Houston last week, only one of the 12 companies that attended said it would enforce a return-to-office policy in performance reviews.
“It was clearly a minority opinion that the others shook their heads at,” said Kris Larson, chief executive of Central Houston Inc., a group that promotes business in the city and sponsored the meeting.
Making matters worse, business leaders and city officials say they see more forces at work that could slow the return to office than those that could accelerate it.
Covid-19 cases are up and will likely increase further in the fall and winter months. “If we have to go back to distancing and mask protocols, that really breaks the office culture,” said Kathryn Wylde, head of the business group Partnership for New York City.
Many cities are contending with an increase in homelessness and crime. San Francisco, Philadelphia and Washington, D.C., which are struggling with these problems, are among the lowest return-to-office cities in the Kastle System index.
About 90% of members surveyed by the Seattle Metropolitan Chamber of Commerce said that the city couldn’t recover until homelessness and public safety problems were addressed, said Rachel Smith, chief executive. That is taken into account as companies make decisions about returning to the office and how much space they need, she added.
Cuts in government services and transportation are also taking a toll. Wait times for buses run by Houston’s Park & Ride system, one of the most widely used commuter services, have increased partly because of labor shortages, according to Larson of Central Houston.
The commute “is the remaining most significant barrier” to improving return to office, Larson said.
Some landlords say that businesses will have more leverage in enforcing return-to-office mandates if the economy weakens. There are already signs of such a shift in cities that depend heavily on the technology sector, which has been seeing slowing growth and layoffs.
But a full-fledged recession could hurt office returns if it results in widespread layoffs. “Maybe you get some relief in more employees coming back,” said Dylan Burzinski, an analyst with real-estate analytics firm Green Street. “But if there are fewer of those employees, it’s still a net negative for office.”
The sluggish return-to-office rate is leading many city and business leaders to ask the federal government for help. A group from the Great Lakes Metro Chambers Coalition recently met with elected officials in Washington, D.C., lobbying for incentives for businesses that make commitments to U.S. downtowns.
Baruah, from the Detroit chamber, was among the group. He said the chances of such legislation being passed were low. “We might have to reach crisis proportions first,” he said. “But we’re trying to lay the groundwork now.”