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28 September 2022

The Bank of England has been forced into a dangerous position

If investors believe the Bank is no longer able to control monetary policy, the UK’s economic crisis will deepen.

By Will Dunn

The Bank of England has announced that it will begin buying government bonds – called gilts – this morning (28 September) in an attempt to avert what it called “a material risk to UK financial stability”. This comes after a massive sell-off of gilts, caused by the programme of tax cuts and borrowing announced by the government at the end of last week, led to a crisis in the market for UK government debt.

The Bank has previously bought very large numbers of government bonds in order to stabilise financial markets (known as “quantitative easing” or QE) following events such as the global financial crisis of 2008 and the arrival on the global pandemic in 2020. It has never needed to do so in response to a government’s fiscal policy, however, and the fact that it is being forced into action now may have even more serious consequences for the UK economy.

The first reason for this is that the Bank’s most urgent job, in a year in which inflation has reached double digits, is to tighten monetary policy – which it does by selling gilts, not buying them, as well as by raising interest rates. It is widely agreed that the current period of inflation is partly caused by the QE used to stabilise markets during the pandemic; more QE is likely to lead to further inflation.

But the second, and potentially more serious, impact of this morning’s events could be that it causes markets to see the UK as an even more risky investment, because its central bank is no longer independent of the decisions of its government – a situation economists call “fiscal dominance”.

Jonathan Portes, professor of economics at King’s College, London, explained fiscal dominance as a situation in which “fiscal policy is not just having negative effects in itself, but it’s also messing up the ability of the bank to conduct monetary policy and the proper functioning of the gilts market”.

“The problem is that the last thing the Bank wants to do is admit that it is in a position of fiscal dominance, because that makes things worse.”

The independence of central banks is not just a political issue; it is vital to investors’ confidence in the value of government debt. “If the Bank has full control of monetary policy, then a bigger budget deficit ought, in principle, lead to a higher exchange rate,” explained Portes, “because if you believe the Bank can do its job, then higher budget deficit means higher interest rates.” This was the success of the US’s programme of “Reaganomics” in the 1980s, when higher government debt and higher interest rates made the dollar stronger.

But if investors believe that the Bank of England is no longer in a position to do monetary policy, they cannot have confidence in the returns on buying sterling, which will have the opposite effect to Reaganomics: the pound, already at a historic low against the dollar, will fall even further.

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The knock-on effect of this would be still more inflation, as the relative prices of imports rises; the UK had a trade-in-goods deficit of almost £62bn in the three months up to July. The difference in prices will be felt particularly in energy imports (which are dollar-denominated), and this will add even more to the cost of the government’s plan for energy bills.

A note from Pantheon Macroeconomics this morning forecast that the Bank’s new bond-buying programme indicates it will not raise rates to the level (around 6 per cent) currently forecast by markets, but predicts that even with a lower-rate rise, “a painful recession driven by surging borrowing costs lies ahead”.

Clearly, the Bank felt that it was left with no choice: this morning, as the Debt Management Office prepared to sell a £4.5bn package of 30-year bonds, one estimate suggested that the final cost of this one debt issuance had risen by more than £2bn in less than a fortnight. But the very fact that it was left with no choice but to bail out a reckless government may only add to the UK’s growing economic crisis.

[See also: Kwasi Kwarteng forgot that radicalism needs to be matched by credibility]