Bank of England intervenes to stabilize UK finances after Liz Truss budget

The central bank acted after investors resoundingly rejected Prime Minister Liz Truss’s plan to use borrowed money to pay for tax cuts while also spending freely to insulate consumers from soaring energy bills. After the government unveiled its proposal on Friday, investors feared it would aggravate 10 percent inflation dumped government bonds and the British pound.

Reaction in the government bond market was particularly intense. By Tuesday, bondholders were demanding roughly 5 percent to lend the British government money for 30 years, almost 1.25 percentage points more than before the tax-and-spending plan was announced.

With sellers outnumbering buyers, the central bank stepped in today to reassure investors that it would buy government bonds “on whatever scale is necessary” to ensure that trading remains orderly.

The alternative would have been to risk a breakdown in the market for government securities, a development that would strangle credit throughout the economy. Already, some British lenders were freezing new mortgage loans and pension funds were facing margin calls that would force them to sell bonds that were sinking in value, according to Barclays Bank.

The U.K. also must attract significant flows of foreign capital to finance its sizable trade and budget deficits, economists said.

Investors largely welcomed the central bank’s action with the yield on the 30-year bond dipping below 4 percent late in the day. The pound, which earlier in the week had reached an all-time low against the dollar of $1.03, stabilized around $1.07.

But the U.K. is not out of the woods. The Bank of England said its bond purchase plan was “strictly time limited” and would expire on Oct. 14. Investors, meanwhile, are hoping next week’s Conservative Party conference will see Truss modify her fiscal stimulus plans.

“This is something that’s designed to buy time as opposed to cure a problem,” said David Page, head of macroeconomic research at AXA Investment Managers in London, referring to the bank’s announcement.

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The International Monetary Fund also weighed in, with an unusual rebuke for a Group of 7 nation economy. “Given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture, as it is important that fiscal policy does not work at cross purposes to monetary policy. Furthermore, the nature of the UK measures will likely increase inequality,” the fund said.

While the new Conservative government faces a difficult policy choice, the central bank also confronts an agonizing set of issues.

Before today’s announcement, the Bank of England was planning to begin next week selling its holdings of government bonds. Those plans have been shelved until Oct. 31.

During the pandemic recession, the bank had purchased a large quantity of bonds to reduce borrowing costs and encourage economic growth. More than two years later, with inflation the main concern, central bank officials wanted to start withdrawing that extra spur for the economy.

Instead, the bank is now effectively helping the government stimulate an economy that already is running too hot.

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Last week, the bank raised its benchmark lending rate by half-a-point to address mounting inflationary pressures.

The events of the past week mean that further rate increases lie ahead.

U.K. financial markets are now pricing in rates of 6 percent early next year, up from the current 2.25 percent, a jump that investors say would devastate the economy.

The unemployment rate would double to 7.2 percent and the economy would fall into a deep recession, Samuel Tombs, chief U.K. economist at Pantheon Macroeconomics, told clients on a webinar Wednesday.

Homeowners would be especially hard hit, since most in the U.K. hold adjustable rate mortgages with repayment costs that reset every two or five years. With large numbers due to refinance in the coming months, a typical borrower who pays 900 pounds ($975) each month would see their mortgage payment jump to 1500 pounds ($1625,) Tombs said.

“You’d see a massive number of households defaulting on their mortgages,” he said.

Likewise, 80 percent of business loans carry floating rate loans. The share of profits the typical company must devote to debt repayment could triple, representing “a massive financing shock for businesses that few have anticipated,” Tombs said.

Rather than raise rates that much and incur a deep recession, the central bank is likely…