The Bank of England goes into full crisis management mode

The Bank of England went into full financial crisis mode on Wednesday, rushing to announce the central bank would restart its money-printing machines to “any extent necessary” and later confirmed it was planning new quantitative easing of up to £65 billion .

Ministers have tried to say that the latest financial turmoil is global, but no one in the markets doubted that the UK’s woes were the result of £45bn in unfunded tax cuts in Chancellor Kwasi Kwarteng’s ‘mini’ budget last Friday were.

Sterling’s fall against the US dollar and the rise in government bond yields since Kwarteng’s financial report have put Prime Minister Liz Truss’ economic policy in acute trouble, and the BoE’s recent QE move raised further questions.

During her campaign for Conservative Party leadership, Truss blamed the BoE’s post-financial crisis QE program – which included printing money to buy £875 billion worth of government bonds to stimulate the economy – as the cause of inflation.

“Some of the inflation was caused by the increase in the money supply,” Truss said in July, but by September her government had authorized the BoE to restart the money printing machines.

Line chart of UK interest rate expectations (%) showing that markets are now expecting much higher interest rates to offset unfunded tax cuts

The BoE said the purpose of its recent purchases of long-dated government bonds was to restore financial stability rather than boost inflation. The central bank tried to prevent an artificial rise in yields on gilts over 20 years that threatened the solvency of pension funds.

But analysts have expressed concern at how Kwarteng and the BoE appear to be pulling in opposite directions – through the Chancellor’s unfunded tax cuts to boost demand and the central bank’s moves to raise interest rates to curb high inflation.

Paul Hollingsworth, economist at BNP Paribas, said: “It’s hard to be coordinated when fiscal policy is stepping on the gas and monetary policy is stepping on the brakes.”

The BoE’s position has been further complicated by the fact that its recent government bond buying move coincides with an attempt to also tighten monetary policy, in part by selling gilts accumulated as part of its post-2009 QE programme. The new government bond purchases leave the central bank vulnerable to accusations that it is fueling inflation.

UK CPI inflation (%) line chart showing fiscal policy and recent BoE intervention threatens to keep inflation high

Bethany Payne, fixed income portfolio manager at Janus Henderson Investors, said: “The Bank of England is generously offering to buy long-dated gilts from today. This is a complete reversal of their announcement last Thursday when they confirmed that gilt sales would take place from Monday 3rd October.”

As these contradictions undermine the credibility of UK economic policy, the big question is what comes next.

The BoE on Wednesday insisted it would stick to its current timeline for rate decisions, with the next meeting of the central bank’s Monetary Policy Committee set for November 3.

Gerard Lyons, chief economic strategist at Netwealth, who has informally advised Truss, said the BoE should avoid inter-meeting rate decisions if possible.

This avoids a sense of panic and it would be difficult to calibrate the scale of rate hikes in an emergency MPC meeting, he added.

The BoE also stressed that it wants to end its recent money-printing efforts quickly: by October 14th. She said the asset purchases were “strictly time-limited,” although BoE officials also noted that the temporary maintenance of intervention was based on a “signaling effect” that worked.

Once financial markets began to appreciate the extent of the BoE’s intervention, central bank officials expected the turmoil to ease and long-dated government bond buyers to return, even if yields remained much higher than in recent weeks.

Kallum Pickering, an economist at Berenberg Bank, said the BoE message was “Don’t fight a central bank in its own currency” because you could lose a lot of money.

However, according to many economists, the BoE’s deeper problem was that by bailouting ministers, the central bank seemed poised to print money to fund the government, something it previously promised never to do because it was inflationary.

They labeled the process “fiscal dominance” because the Treasury would call the shots, with the result that inflation could spiral out of control.

Allan Monks, economist at JPMorgan said: “The optics are not favorable for the bank and will inevitably lead to discussions of fiscal dominance and monetary funding [budget] Deficit.”

“The return of asset purchases in the name of market functioning is potentially justified; However, this policy action also raises the specter of monetary finance, which could increase market sensitivity and force a change in approach,” said Robert Gilhooly, senior economist at Abrdn.

Over at the Treasury Department, Kwarteng, who is scheduled to deliver a keynote speech at the Conservative Party convention on Monday, came under pressure to explain how his unfunded tax cuts could coexist with sustainable public finances. The IMF launched a scathing attack on Kwarteng’s tax cuts on Tuesday, urging the government to “reassess” the plan as the “untargeted” measures threatened to fuel rising inflation.

David Page, Head of Macro Research at Axa Investment Managers, said: “Recent government policies of ignoring economic realities are politically very damaging, but they are also proving to be economically damaging.”

He added that the chancellor has “an opportunity to turn back” by next week’s speech [on his mini-Budget tax cuts and a] A refusal to change course is likely to put pressure on UK financial markets and magnify the longer-term economic damage.”

Truss and Kwarteng have so far refused to tolerate a reversal. While financial markets, the IMF and some Conservative MPs would prefer a reversal of the Chancellor’s tax cuts, that currently seems the most unlikely path. The Bank of England goes into full crisis management mode

Adam Bradshaw

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