Two things have become clear over the past few days. The first is that the UK really does have an inflation problem. The second is that this country also has a government borrowing problem, both in its cost and its extent.

Hard on the heels of ministers celebrating that growth in UK gross domestic product (GDP) in the first half of the year was the strongest in the G7 (America, Canada, France, Germany, Italy, Japan and the UK) came the unwelcome news that inflation, at 3.8 per cent, was also the highest in the G7. You win some, you lose some, and I suspect people notice high inflation rather more than the modest flowering of growth.

As for government borrowing, even people who do not follow these things — and may not know what a gilt is — spotted something worrying happening. A gilt is a UK government bond, and the yield or market interest rate on 30-year gilts rose last week to its highest since May 1998, topping 5.6 per cent before edging lower.

May 1998 was in the very early days of Bank of England independence, when the official interest rate was a high 7 per cent (and about to rise further), consumer prices inflation was 2 per cent and government borrowing — the budget deficit — was falling sharply on its way to a temporary budget surplus.

Thirty-year gilt yields at a 27-year high, and 10-year yields at their highest since 2008, is clearly not a good thing. Both are higher than when Liz Truss was prime minister, though against a backdrop then of Bank rate averaging 2 per cent, and comparisons between the chaos then and the situation now are not valid — although if the Treasury keeps flying strange kites about future tax hikes, that may not remain so.

There is a legacy from three years ago. Gilt yields began to break away from the advanced-country pack in autumn 2022, when inflation hit 11 per cent and confidence in the UK’s public finances slumped. Before that, 10-year gilt yields were below their US equivalent, treasuries, and also below Italy and Canada, and closer to French and German government bond yields.

Why is this happening? When the UK has the highest inflation rate, it is perhaps not surprising that government borrowing costs are the highest, too. Inflation also adds directly to the cost of government borrowing, via the inflation uplift on index-linked gilts. Curiously, though, both 30-year and 10-year gilt yields fell in the hours after the release of the latest inflation figure, suggesting other forces are also at work.

• Borrowing costs rise again as gilt yields near 27-year high

Some of those other forces are domestic, some international, and separating the two is not easy. On the domestic front, continued high levels of public borrowing, tied to the government’s recent U-turns on cuts in winter fuel payments and disability benefits, are clearly a factor.

Last month’s public borrowing figures were marginally better than expected, though accompanied by an upward revision to June’s figures. July borrowing of £1.1 billion was £2.3 billion lower than a year earlier, though April-July, at £60 billion, was £6.7 billion higher than in 2024.

The danger signals are not yet flashing red, because borrowing is in line with projections from the Office for Budget Responsibility (OBR), which always thought it would be front-loaded and end up lower than last year.

Crucially, though, the OBR noted that the current budget deficit, which the fiscal rules require to be eliminated, was £42.8 billion in April-July — £5.7 billion, or 15 per cent, above forecast. This is borrowing for day-to-day spending.

The big picture is that the public finances remain sickly — but talk of a £50 billion black hole, which has entered the vocabulary, is excessive. Martin Beck, chief economist at the communications consultancy WPI Strategy, says talk of a huge black hole is overstated but that the public finances are still “uncomfortably tight”.

Andrew Wishart of Berenberg bank said that only “a modest repair job” would be needed in Rachel Reeves’s autumn budget, which makes it surprising that the Treasury is setting so many tax hares running. The latest “flash” purchasing managers’ index (PMI), suggesting a strengthening of growth this month, is another positive sign. Consumer confidence is even edging higher.

Having fallen after worse than expected inflation figures, gilt yields rose a little after the better than expected data for the public finances. That suggests other things were happening, as they were.

Gilt yields edged up on the morning of the public finance figures in response to a set of minutes released by the Federal Reserve, America’s central bank, the previous evening. They suggested that its decision-making committee remained cautious about cutting interest rates.

What happens in America does not stay in America, and interest rate decisions by the Fed are a big driver of bond markets worldwide, including the UK gilt market. The release of weak US jobs data, after which Donald Trump sacked the official ultimately responsible for them, led to hopes earlier this month of a succession of rate cuts by the Fed, starting next month. In response, the 10-year gilt yield fell to 4.5 per cent and the 30-year yield to 5.3 per cent. That markets are no longer so sure about those US rate cuts largely explains the rise since then.

These are not the only factors. A big structural change is affecting demand for gilts. This is the decline of defined-benefit — mainly final salary — pension schemes, which traditionally provided much of the demand for long-dated gilts. One recent estimate suggested that pension schemes will become marginal holders of long-dated gilts, at best, by the end of this decade. The share of insurance companies and pension funds in overall gilt holdings has come down from two-thirds to less than a quarter in two decades.

Some of those holdings have been taken up by the Bank of England under quantitative easing (QE), and a big decision is looming on that. The Bank currently has £586 billion of gilts on its balance sheet, down from a peak of £875 billion three years ago.

It must decide next month by how much to run down those holdings over the next 12 months under its policy of quantitative tightening (QT), and whether to stick with a £100 billion-a-year target. A lower target should in theory reduce the upward pressure on gilt yields and even exert some downward pressure.

That is an important issue. In the end, however, lower gilt yields will happen on a sustainable basis only when markets decide that the UK has got over its inflation problem and finally got to grips with the budget deficit.

• Gilts wobble passes, but who’s driving the UK economy now?

There are good reasons to think inflation will come down next year, as a series of one-off price rises drop out of the annual comparison. There were also straws in the wind in the latest borrowing figures to suggest that it will be possible to turn around the borrowing super tanker.

Whether that will be enough to convince markets to take the UK off the naughty step when it comes to government borrowing costs remains to be seen. It cannot come soon enough.

PS

There is always something interesting in the detail of the inflation figures, which so far have not fallen victim to the “Newport curse” affecting some key statistics, the latest being retail sales, though there was a small inflation miscalculation back in the spring. Newport in south Wales (called Mudtown in a new TV series) is where the Office for National Statistics moved to nearly 20 years ago.

Anyway, the latest figures suggested that healthy eating is good for your wallet as well as your body. Over the 12 months to July, fruit prices were up by 3.5 per cent and vegetables by 2.6 per cent. This compared with 6.1 per cent for meat and 10 per cent for “sugar, jam, syrups and confectionery”. Yum.

I’m a little obsessed with coffee prices and they, along with tea and cocoa, were up by an alarming 13.1 per cent last month on a year earlier. It may be better to drink wine, up 2.4 per cent, rather than beer, up 4.8 per cent.

You may know about the inflation in air fares, 15.5 per cent last month, nearly three times as much as rail fares, 5.4 per cent. I feel honour bound to mention newspapers and periodicals, good for any journey, with a high 11.1 per cent inflation rate. Still worth every penny.

I also feel honour bound to mention insurance premiums, which I highlighted as rising very sharply during the pandemic. That is no longer the case. Insurance premiums last month were 4.7 per cent down on a year earlier, with house contents cover down 7 per cent, medical insurance 2.5 per cent lower, and transport cover (mainly for cars) 8.5 per cent lower. Excellent.

david.smith@sunday-times.co.uk