The central bank acted after investors vehemently rejected Prime Minister Liz Truss’ plan to use borrowed money to pay for tax cuts while spending freely to protect consumers from rising energy bills. After the government unveiled its proposal on Friday, investors feared it would exacerbate 10 percent of government bond-dumping inflation and British pound.
The reaction in the government bond market has been particularly severe. By Tuesday, bondholders were asking for nearly 5 per cent to lend the British government money for 30 years, about 1.25 percentage points higher than before the tax and spending plan was announced.
With sellers outnumbering buyers, the central bank intervened today to assure investors that it will buy government bonds “on whatever scale is necessary” to ensure trading remains orderly.
The alternative was to risk a government stock market crash, a development that would choke off credit throughout the economy. Already, some British lenders were freezing new mortgages, and pension funds were facing demands for margin that would force them to sell depreciating bonds, according to Barclays.
Economists said the UK should also attract large inflows of foreign capital to fund its large trade deficit and budget.
Investors largely welcomed the central bank’s action as the yield on the 30-year bond fell below 4 percent late in the day. The pound, which earlier in the week reached an all-time low against the dollar at $1.03, settled around $1.07.
But the UK is not out of the woods. The Bank of England said its bond-buying plan was “time-limited” and will expire on October 14, meanwhile, investors at next week’s Conservative Party conference are hoping to see Gears adjust its fiscal stimulus plans.
“This is something designed to buy time rather than cure a problem,” said David Page, head of macroeconomic research at AXA Investment Managers in London, referring to the bank’s announcement.
The International Monetary Fund also intervened in an unusual rebuke to the G7 economy. “Given high inflation Pressures In many countries, including the UK, we do not recommend large and untargeted fiscal packages at this point, as it is important that fiscal policy not operate for purposes inconsistent with monetary policy. Moreover, the nature of British actions is likely to increase inequality.”
While the new Conservative government faces a difficult political choice, the central bank also faces a painful set of issues.
Prior to today’s announcement, the Bank of England was planning to start next week selling its holdings of government bonds. These plans have been postponed until October 31.
During the pandemic recession, the bank purchased a large amount of bonds to reduce borrowing costs and encourage economic growth. After more than two years, with inflation The main concern is that central bank officials wanted to start withdrawing this extra stimulus to the economy.
Instead, the bank is now actively helping the government stimulate an already overheated economy.
Last week, the bank raised its benchmark lending rate by half a point to tackle rising inflationary pressures.
The events of the past week mean that more price increases await us.
UK financial markets are now pricing rates at 6 per cent early next year, up from the current 2.25 per cent, a jump that investors say will destroy the economy.
The unemployment rate will double to 7.2 per cent and the economy will fall into a deep recession, Samuel Tombs, chief UK economist at Pantheon Macro Economics, told clients in a webinar on Wednesday.
Homeowners will be hit particularly hard, as most in the UK have adjustable rate mortgages with resettlement costs paid out every two or five years. With the high numbers due to refinancing in the coming months, Tombs said, the average borrower paying 900 pounds ($975) a month would see mortgage payments rise to 1,500 pounds ($1,625).
“You will see a huge number of families who are struggling to pay their mortgage loans,” he said.
Likewise, 80 percent of business loans carry variable rate loans. Tomps said the share of profits that a typical company would have to set aside to pay off debt could triple, representing “a massive financing shock to companies that few expected.”
He said that rather than raise interest rates too much and endure a deep recession, the central bank is likely to allow the pound to weaken further instead.
The Bank of England is likely to disappoint investors by raising interest rates at its next meeting in November by three-quarters of a point, well below the 1.8 percentage points markets are pricing in, Ajay Rajadiaksha, chair of global research at Barclays, wrote in a research note.
Truss, who is only three weeks in the works, is trying to transform Britain’s economy with bold – some might say risky – measures that have spooked investors.
On Friday, it delivered on its promise as the government announced huge tax cuts and a big jump in borrowing. The plans include eliminating the highest income tax rate of 45 percent for people earning more than 150,000 pounds and eliminating the maximum limit for bankers’ bonuses.
“This, unlike other market volatility, has wound its own,” Keir Starmer, leader of the opposition Labor Party, told the BBC on Wednesday morning. His party is up 17 percentage points, according to a recent YouGov poll. This is the party’s biggest advance against the Conservatives since 2001, when Labor leader Tony Blair scored a landslide victory.
Truss will have to call a general election by January 2025 and is eager to put her ideas about the economy into practice.
Truss and her advisor, Kwasi Quarting, defended their vision of the economy. However, neither of them issued public statements this week to address the deepening crisis.
“They are willing to risk losing popularity because they believe it will work in the long run,” said Tony Travers, professor of politics at the London School of Economics.
He noted that, unlike some of her Tory predecessors, including Johnson and Theresa May, Truss’s views of the free market were crystal clear. Her government wants to “transform Britain into a less taxed and more resilient economy that competes head-on with high-paid and talented workers with the European Union and the world”.
“Whether it works or not, only time will tell,” he said, adding, “Whether it works in the short term, time will tell soon.”
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