The lower cost of government borrowing isn't strictly positive

The Times front page has a story about a windfall coming to George Osborne (£) in the next budget due to lower-than-expected inflation and the declining interest payments. Capital Economics calculates the borrowing cost will be £21 billion lighter over the next 5 years.

This is welcome news to a Chancellor who has staked his credibility on eliminating the deficit. But he is no stranger to using such windfalls to cancel spending cuts - at the Autumn Statement he used a £27 billion improvement in the OBR’s forecasts to cancel planned cuts to departmental budgets and tax credits.

The main reason for this new windfall is the steadily declining return on government bonds, also known as gilts. This means borrowing costs are falling.

(See here for more information on how gilts work)

But as fortunate as it may be for the current Government, this isn't a reason to start splashing the cash.

Gilts are seen as a very safe investment since the government is very unlikely to default. It has an extremely high credit rating because it can levy taxes. So in uncertain economic times you’re likely to find investors holding more of their income in gilts and less in other assets such as stocks and shares.

Because of the continual budget deficits the government is running, we’re in the midst of a gilt glut - over the last 7 years the government has been issuing far more debt than usual, relying on demand to remain strong in order to continue borrowing at such low costs.

In summary,  the government is issuing a lot of gilts but there’s still a lot of demand for them. There’s been so much uncertainty in the markets that even a massive increase in supply hasn't done much to dent the return.

One day this will change. Interest rates and inflation will go up, increasing borrowing costs. And the UK is not best placed to deal with this as more of our bonds are inflation linked and the maturity of them is longer than other countries’.

The Bank of England performs analysis to ‘stress test’ the banking sector so it can be prepared for an external shock. The government budget could do with similar analysis, especially when such a reliable indicator of economic headwinds is showing problems ahead.

The chancellor must stop using borrowing to fund day-to-day spending and close the deficit quickly, rather than spending any windfall he must stick to his own words and ‘fix the roof while the sun is shining’.