Gilts and guilt

Whoops.

This government has suffered its first setback in financing its eye-wateringly large borrowing needs.

And what gives resonance to the flop of a relatively modest sale of gilts or government bonds is that it comes a day after Mervyn King warned the Treasury against further augmenting public-sector borrowing through an additional fiscal stimulus (via tax cuts or an increment in public spending).

What's happened is that the Debt Management Office - an offshoot of the Treasury - had wanted to raise £1.75bn through the sale of a 40 year bond (this is the equivalent of the government borrowing for 40 years), but received acceptable bids for only £1.63bn.

There was a shortfall of just over £100m.

Now £100m may seem trivial in the context of the government's overall borrowing needs: the Debt Management Office reckons it will have to sell £147.9bn of gilts in 2009-10, to finance the public-sector's ballooning financing requirement; and some analysts fear that gilt sales may in the end have to be as much as £200bn next year, such is the deterioration in the public finances.

But it's because the government has to borrow so much, that any such flop is unnerving.

This auction is the first time that there has been less than 100% demand in a sale of gilts since 2002, and in that case the auction was of index-linked or inflation-proofed bonds. There hasn't been a flop of a conventional gilts auction since 1995.

So what's going on? And how alarming is the failure?

Well it would be wrong to read too much into one glitch of this sort. In the past 11 months, the Debt Management Office has successfully sold a colossal amount of new government bonds, well over £140bn, without encountering difficulties.

An accident was perhaps bound to happen at some point.

But it would be equally unwise to dismiss the flop as a non-event.

The important question is why investors' appetite for government bonds has been reduced.

The main reason appeared to be the uncertainty created yesterday by the governor of the Bank of England about the volume of gilts the Bank of England would buy through its Quantitative Easing programme.

He told MPs on the Treasury Select Committee that the Bank would reduce its purchases of gilts if there was evidence that the threat of deflation was being lessened.

In that context, the disclosure yesterday that inflation had risen on the Bank of England's official target measure - the Consumer Price Index - prompted some analysts to conclude that deflationary risks may have been overstated just a bit and that the Bank may therefore be a little more modest in its purchases of gilts than had been expected.

To state the obvious, if the Bank were buying fewer gilts there would be more for ordinary investors to buy - and their appetite for UK sovereign debt isn't unlimited (though, as it happens, the Bank was never going to buy 40-year gilts).

Which, of course, is why the governor's publicly expressed anxiety about the magnitude of the government's prospective borrowing needs is so resonant.

It would probably be silly to argue that Mervyn King is to blame for the flop of the gilts auction.

The painful fiscal reality is to blame, or forecasts such as that of the International Monetary Fund that the budget deficit next year will be equal to 11% of GDP, a record-breaking funding gap.

That said if the prime minister had hopes of stimulating the economy further through spending and tax cuts, he may feel that investors (or what you might call Mr Market) are ganging up with the governor to dash those hopes.