Bank of England U-turn offsets risks
Although your purchase of bonds may indicate that you support the government that has created the problem, it is worth
The Bank of England has kicked off a necessary series of economic shifts. British Prime Minister Liz Truss’s plan to cut taxes has sent the pound and bond prices plummeting. The decline makes it even more difficult for Governor Andrew Bailey to convince markets that he can tighten monetary policy. His decision on Wednesday to buy British government bonds and delay plans to sell his 857 billion pound (948 billion euro) bond portfolio carries big risks. But it can facilitate the necessary rate hikes.
Truss’s unfunded tax cuts, unveiled on Friday, caused an uproar in the debt market. Britain’s 10-year bond yield has soared more than a percentage point since that day, as investors dump British assets on fears of runaway spending and inflation.
Bailey has to convince the market that he will act late to stop the price rise. That means being willing to raise rates, even at the expense of slowing growth and raising borrowing costs for homeowners and businesses.
The turmoil comes at an especially bad time because, like the Fed, the Bank of England has been preparing to reverse its quantitative easing policy. This involves reducing the portfolio of bonds you bought in the recent financial and economic crises. Bailey’s goal is to reduce holdings by 80 billion pounds (88 billion euros) over the next year. This so-called quantitative tightening would require asset managers and investors to buy more bonds, even as the government raises debt. The prospect scared the markets. By Wednesday morning, benchmark UK 30-year bonds, for example, had lost more than 20% of their value since Friday.
The figures are discouraging. UBS estimates that the issuance of gilt, After accounting for sales and write-downs from quantitative easing, it will hit £355bn (€393bn) in the year ending March 2024. That’s more than the past three years combined.
There were already signs that government debt markets were beginning to malfunction. One was the growing difference between the interest rate at which agents buy and sell bonds, the so-called bid-ask spread. A trader he said that brokers were talking about a spread of 4 basis points for two-year bonds, against a normal level of 1 basis point.
The Bank of England’s response to what it called “dysfunction” in the markets is thus logical and effective: bond yields fell sharply after the announcement. But it has a cost. There is a clear danger that the bank appears to be subsidizing the government whose misguided policies created the turmoil. But a more orderly bond market will also make it easier for him to use his main policy weapon, raising rates. If Bailey can now tighten monetary policy without scaring off investors, his turnaround will have been worth it.
