According to Andrew Bailey, the central bank’s responsibilities for monetary policy and financial stability are working against each other.
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On a bright Tuesday in Washington, Andrew Bailey gambled his entire career when he spoke to bankers at the Institute of International Finance.
The BoE governor decided to use his appearance at the financial industry representative body to play a game of chicken with the markets in the midst of all the chaos that followed chancellor Kwasi Kwarteng’s “mini” Budget.
Bailey ruled out extending the emergency bond-buying program of the central bank, which was started after Kwarteng’s fiscal statement threatened multiple pension schemes with insolvency due to a sharp rise in gilt yields.
He delivered a stern message to the pensions sector, advising it to resolve its issues before the program’s scheduled expiration on Friday. “You still have three days. You must complete this, said Bailey.
Before delivering this well-rehearsed soundbite, Bailey gave an explanation of his reasons for adopting a rigid stance.
He insisted that the situation did not resemble that of the Covid-19 pandemic’s early stages, when the BoE printed large amounts of money, acquired assets at essentially any price, lowered interest rates, and did not set a time limit on the intervention.
He referred to the dual pressures on the BoE to tighten monetary policy to lower high inflation as well as take action to bring order back to the government bond market, saying, “We’ve got two things going in opposite directions.”
According to Bailey, “We were going to start [quantitative] tightening, raising interest rates, and having to offer to buy gilts at the same time.” He asserted that the BoE financial stability operation’s time limit was justified by these conflicting pressures.
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Insiders at the BoE are certain that the governor and the central bank are in a very precarious situation, which was brought on by the government’s £43 billion in unfunded tax cuts included in the mini Budget, which alarmed the markets.
Though there are three main risks the BoE is facing, they are hoping that the Friday deadline for the central bank to wrap up its gilt-buying operation will inspire pension funds and provide everyone with a way out.
Mixed messages pose the first threat. According to sources briefed on the discussions, The Financial Times reported on Wednesday that BoE representatives had told some banks that they were ready to extend the bond-buying facility past October 14 if market conditions required it.
In a later statement, the BoE stated that it had informed banks “at senior levels” that its “temporary and targeted purchases of gilts will end on October 14.”
While the BoE claimed that banks had been informed at a senior level that the program would end on Friday, one industry participant in the discussions between BoE representatives and the banks later remarked: “We were also being told that they would do whatever it takes to stop this from becoming a systemic crisis and would consider extending it. Those two statements are likely accurate.
It was reasonable for banks to believe the central bank’s bond-buying program could be extended, according to former BoE officials.
Former BoE deputy governor Sir Charlie Bean stated that “the bank will have to step in again” if financial stability risks persist at the end of the week.
Sending such a stern message to pension funds and their liability-driven investment providers was quite a risk because Bailey cannot guarantee that the BoE bond-buying operation will end on Friday and is aware that under pressure he will be forced to keep the facility in place. It could go wrong.
The possibility of tensions with the government after a brief period in which Kwarteng has praised economic orthodoxy and expressed his appreciation for the independent central bank represents the second risk for Bailey and the BoE.
Chief Treasury Secretary Chris Philp declared on Wednesday that he had “complete confidence in [BoE officials’] ability to manage systemic financial stability,” but other ministers were less complimentary.
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Business Secretary Jacob Rees-Mogg ascribed the recent market turmoil to the BoE, claiming it was due to the latter’s inability to raise interest rates as quickly as the US Federal Reserve.
He added that the issues had “much more to do with interest rates than it does with a minor aspect of fiscal policy.”
Insiders at the BoE disagree with this viewpoint and believe they are stuck dealing with a situation that was not their fault.
They concur with the IMF that the government’s lax fiscal policy has interfered with their efforts to reduce inflation.
Bean argues that the BoE cannot be seen as subsidizing government borrowing costs or “doing anything that would be interpreted as helping government out of a hole” due to Kwarteng’s unfunded tax cuts.
Historically, lowering borrowing costs for countries with unsustainable fiscal policies has been the path to hyperinflation.
As if these first two risks weren’t challenging enough, the BoE is also experiencing internal problems related to its dual responsibilities of establishing monetary policy and preserving financial stability.
On Tuesday, Bailey emphasized how the two policymaking sectors were moving in different directions.
Huw Pill, the chief economist for the BoE, suggested on Wednesday that the two policies were complementary to one another.
By using the bond-buying intervention to restore market functionality, he claimed that “risks of contagion to credit conditions for UK households and businesses are reduced, and such actions preserve the effective transmission of monetary policy.”
However, his consoling words only hold true if the BoE’s actions to lower gilt yields are only momentary.
As Bailey noted, monetary policy would not be able to set an interest rate that was high enough to control inflation if they were permanent.
Combining these three risks, Bailey faces a number of potential problems over the coming days as he prepares for the possibility of the markets calling his bluff.
If, in order to restore calm, the BoE must start buying bonds again after Friday, his credibility will be severely harmed.
The governor does, however, have one piece of good news: Lord Mervyn King experienced exactly this fate in 2007.
When a run on the bank began a few days after the then-BoE governor warned that any bailout of Northern Rock would encourage moral hazard in a letter to the House of Commons Treasury committee, he was forced to retract his statement.
King continued to serve as governor despite that catastrophe until his term ended in 2013.
Additional reporting from London’s Owen Walker
