The Bank of England moved Wednesday to quell a financial market revolt, announcing that it would temporarily buy an unlimited quantity of government bonds to prevent disorderly trading from destabilizing the British economy.
The central bank acted after investors resoundingly rejected Prime Minister Liz Truss’s plan to use borrowed money to pay for tax cuts while spending freely to insulate consumers from soaring energy bills. After the government unveiled its proposal Friday, investors fearing it would aggravate inflation that is already near 10 percent dumped government bonds and the British pound.
Reaction in the government bond market was intense. By Tuesday, bondholders were demanding a yield, or interest rate, of 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 on Wednesday 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.
Britain 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 of $1.03, stabilized around $1.07.
U.S. stock and bond markets also applauded, with the Dow Jones industrial average rising nearly 2 percent to close at 29,683.74 and the yield on the 10-year Treasury note, which moves opposite the price, dropping to 3.7 percent.
But Britain 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 that at next week’s Conservative Party conference, Truss will modify her fiscal stimulus plans.
“This is something that’s designed to buy time as opposed to cure a problem,” said David Page, the head of macroeconomic research at AXA Investment Managers in London, referring to the bank’s announcement.
The International Monetary Fund also weighed in, with an unusual rebuke for a Group of Seven economy. “Given elevated inflation pressures in many countries, including the U.K., 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 U.K. measures will likely increase inequality,” the fund said.
President Biden is being kept informed of developments, Jared Bernstein, a member of the White House Council of Economic Advisers, told an audience at the Peterson Institute for International Economics. But there is little danger that Britain’s weakness could spread to the U.S. economy.
“We’re clearly, in our view, not looking at a 2007, 2008 situation where there was really very consequential financial contagion from the implosion of the housing bubble,” he said.
Before the intervention announcement Wednesday, the Bank of England was planning next week to begin 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 economic spur.
Instead, the bank is now effectively helping the government to stimulate an economy that already is running too hot.
Last week, the bank raised its benchmark lending rate by a half-point to address mounting inflationary pressures.
The events of the past week mean that further rate increases lie ahead.
British 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, the chief U.K. economist at Pantheon Macroeconomics, told clients on a webinar Wednesday.
Homeowners would be especially hard-hit, since most in Britain 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 face a jump in their mortgage payment to 1,500 pounds ($1,625), Tombs said.
“You’d see a massive number of households defaulting on their mortgages,” he said.
Likewise, 80 percent of business loans carry floating interest rates. The share of profit 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 to allow the pound to fall further, he said.
The Bank of England is likely to disappoint investors by increasing rates at its next meeting in November by three-quarters of a percentage point, far less than the 1.8 percentage points markets are pricing in, Barclays global research chairman Ajay Rajadhyaksha wrote in a research note.
Truss, who is just three weeks into the job, is trying to change the British economy with bold — some would say risky — actions that have unsettled investors.
On Friday, the government announced huge tax cuts and a big jump in borrowing. The plans include abolishing the top income tax rate of 45 percent for people earning more than 150,000 pounds ($163,000) and scrapping the cap on banker bonuses.
“This, unlike other fluctuations in the market, is a self-inflicted wound,” opposition Labour Party leader Keir Starmer told the BBC on Wednesday morning. His party is 17 percentage points ahead of the Conservatives, according to a recent YouGov poll. This is the party’s biggest lead against the Tories since 2001, when the Labour leader Tony Blair won a landslide victory.
Truss will have to call a general election by January 2025 and is keen to put her ideas on the economy into motion.
Truss and her chancellor, Kwasi Kwarteng, have defended their vision for the economy. But neither has made a public statement this week to address the unfolding crisis.
“They are prepared to risk unpopularity because they think it will work in the long term,” said Tony Travers, a politics professor at the London School of Economics.
He noted that, unlike some of her Conservative Party predecessors, including Boris Johnson and Theresa May, Truss’s free-market views were quite straightforward. Her government wants to “move Britain to be a lower-tax, more flexible economy which competes head-to-head with highly paid workers and talent with the E.U. and globally,” he said.
“Whether it works or not, only time will tell,” he said, adding, “Whether it survives the short term, time will tell sooner.”