Commentary: Inflation-linked worries for gilts

The City is inclined to shiver when it contemplates the scale of the Government's demands on the capital markets next year. On the usual assumptions about flows into National Savings, the Treasury will need to raise perhaps pounds 45bn to fund its deficit and redeem some pounds 7bn of maturing gilts. Since a reasonable guess is that cash flow into institutions next year will be a little below pounds 40bn, there has been some gnashing of teeth about the prospects for gilts prices. And if gilts prices fall, raising their yield, how resilient is the bull case for shares?

This gloomy arithmetic, however, crucially depends on the assumption that the Government maintains the rule introduced by Nigel Lawson in 1985 that the deficit should be fully funded outside the banking system. If people prefer to deposit cash with the banks rather than buy gilts, why not sell more gilts to the banks? The monetary effect would be to boost bank deposits, and hence the money supply. But broad money is growing too slowly anyway.

The interesting question then becomes the reaction of the banks. The executive committee of Lloyds Bank often spends part of its Monday morning meeting discussing the question of whether inflation will stay low or not, according to Brian Pitman, the bank's chief executive. The immediate reason for these discussions is that if low inflation and interest rates persist, they will force fundamental changes in the way the bank prices and sells its products. But a sub-theme is that if banks such as Lloyds decide that low inflation is here to stay, they will indeed want to buy more government bonds.

There was a time when banks lent half their deposits to customers and put much of the rest in government securities, taking a nice steady turn on the money without apparent risk. But investing in government bonds is a dangerous speculative game if prices are unstable, and is currently favoured only by banks in low-inflation countries such as Germany.

British inflation has fallen to levels that on paper should soon justify a return to large-scale purchases of gilts by banks. The yield curve, from under 6 per cent at the short end of the market to 8.7 per cent at the longest, is not yet as steep as in the United States. But there is plenty of scope for profits by borrowing cheap and short-term from customers to lend longer to the Government - provided, of course, that banks can be confident that inflation will stay low. This is a judgement that will not be taken lightly. Imagine the size of the new black hole in the banks' profits if gilts yields double and prices halve, after they have raised their gilts holdings to pounds 20bn or so. The write-downs would be as expensive as those on Third World debt or property lending, and it would be no good blaming the Chancellor of the day.

The decision whether to move heavily into bonds or not is separate from whether the Government changes the funding rules. Only if they believe the case for gilts will banks buy them, and no amount of tinkering with the rules will persuade them if they do not want to.

The Government could be imaginative, coming up with new forms of gilts that index capital values, or at least provide a safety net. It will need to do so if it is also to appeal to foreigners, an important market for gilts next year. But at the end of the day, bank directors may take a sceptical view of conventional bonds. As Mr Pitman says: 'If you believe inflation will come back you will be extremely cautious about buying bonds. Sooner or later you will catch a cold.'