The Bank of England’s surprise decision to intervene in the bond market by buying long-dated government bonds is a prudent move, not a sign of panic.
It won’t stop U.K. yields
from continuing to go up (and they initially plummeted), nor will it stop the pound
from weakening against the dollar and other currencies. However, it will ensure that the U.K. has a functional sovereign bond market, which is crucial for the survival of the economy.
Viewed with this narrow lens, the BOE has drawn a line that is likely to hold. Further, the U.K.’s current problems won’t trigger a broader global crisis.
While the move does not solve the many economic challenges faced by the U.K., it buys policy makers time to address those challenges.
To take a step back, the U.K. economy has deteriorated meaningfully over the last year on a combination of high inflation, slowing growth, war in Ukraine and the strength of the dollar. This challenge has been further exacerbated by the election of a new government and a set of new policies of steep tax cuts and fresh surge in spending.
While the BOE had already started down the path of unwinding its easy-money Covid-era policies by raising interest rates and developing plans to reduce its balance sheet, the new fiscal mini budget released on Sept. 23 has clearly upended those plans. The central bank remains under tremendous pressure to respond to the easing by tightening monetary policy even more aggressively. As economic experts have argued, to counter the expansionary fiscal policy and control further rise in inflationary pressures, the BOE should raise rates even more than previously planned. The tighter monetary policy is likely to unfold over the next few quarters.
However, for the BOE’s plan to eventually work and have any impact on inflation, it has to have a functioning sovereign bond market. Over the last few days, the market for U.K. bonds, known as Gilts, was anything but functioning. All market participants were leaning on one side and rates jumped higher and the currency sank in quick order. That is not an environment where transmission of policy was likely to be orderly. Long gilt yields bond yields were surging by 1.5 percentage points in a matter of days and the pound, also known as sterling, briefly hit its lowest level since the mid-1980s.
The problem was further compounded by the structure of U.K. pension plans, which had hedged a lot of their interest-rate exposure. While the rise in rates did not change their funding positions, as they were hedged, it required them to provide huge amounts of collateral for their hedging positions.
Faced with a combination of a dysfunctional sovereign debt market and the risk of financial instability, the BOE had to step in.
I believe this is the right strategy.
While critics may call the new BOE policy quantitative easing (QE) and bailout of pensions, it is nothing like QE. While the BOE balance sheet will certainly expand, that is only one aspect of QE. Policy makers haven’t set any target for interest rates or established a policy for monetary easing. Nor have they established any target for the currency.
Not only would both of those objectives have failed, they would be counter to the overarching goal of containing inflation.
But it is the obligation of a central bank to ensure that the bond markets remain functional. All of their actions have to be seen in this light. And on that front the BOE has succeeded. The quick reduction in gilt yields by more than a percentage point certainly proves the point that the bond markets weren’t functioning properly.
At the same time, it is still worth remembering that the U.K. and the BOE face tremendous challenges. A lot of work needs to be done to cool economic activity and control inflation which is running in double digits, and that is the government’s task. But any policy initiatives on that front would not have worked with a dysfunctional Gilt market or a financial crisis unfurled by the pension plans. The BOE action today helps in moving down that tough path and therefore is the right move.
Krishna Memani is the chief investment officer at Lafayette College in Easton, Penn. Follow him on Twitter @KrishnaMemani.