Andrew Bailey is in an unenviable position. As Governor of the Bank of England, he must curb inflation, which is rising at its fastest pace in 40 years.
And now he must also undo much of the early impact of the policies of Liz Truss, the British Prime Minister, and her fledgling government, whose tax cut agenda sent shockwaves through British financial markets.
Mr Bailey has a long list of challenges, including restoring order to a dysfunctional bond market, preventing the turmoil in the pension fund industry from causing a full-blown financial crisis and protecting the central bank’s independence from government.
Mr Bailey sits at the head of the central bank and has two tasks to manage: keep inflation low and stable and ensure the UK’s financial stability. In the weeks since the government released its tax cut plan on September 23, his efforts to do both have clashed, resulting in complicated and sometimes conflicting messages and jeopardizing the credibility of the 328-year-old bank.
“The Bank of England was in an incredibly difficult situation prior to the financial news,” said Kristin Forbes, professor of management and world economics at the Massachusetts Institute of Technology and former member of the Bank of England’s interest rate setting committee. “Britain has been hit with a double whammy” of rising energy prices caused by Russia’s war in Ukraine and an extremely tight labor market, “both of which are driving up inflation and require a monetary policy response and slower growth to balance reach.”
“Then the tax announcement caused significant concern,” she added.
Government policies have prompted warnings that fiscal policy should not undermine central banks’ efforts.
On Thursday, Kristalina Georgieva, the managing director of the International Monetary Fund, said the result will be higher interest rates and tighter financing conditions. “Don’t prolong the pain,” she advised at a news conference.
Fiscal policy should be guided by evidence, she added, and if “there needs to be a recalibration, it’s right that governments are doing it.” There were reports in the UK on Thursday that Ms Truss may be considering a policy reversal, news the market took to heart as sterling rose and bond yields fell on Thursday afternoon.
The weeks of turmoil in UK markets and the risks posed by fiscal policy are unique, but the challenge of setting economic policy when options are constrained by the highest inflation in decades is a dilemma facing lawmakers and policymakers around the world share. Market volatility is high in many countries and there is a temptation to spend heavily to protect households from the rising cost of living. Maintaining the right mix of spending to fight inflation without scaring off investors is becoming increasingly difficult.
It doesn’t help Mr. Bailey that he has been heavily criticized for much of the past year, as lawmakers including Ms Truss and some analysts have criticized the central bank for failing to control inflation. His entire tenure as governor has been turbulent: he took office just days before Britain’s first Covid-19 lockdown in March 2020, when global financial markets were in turmoil.
The clock is ticking at a potential hot spot at the Bank of England. The sudden rise in bond yields in late September after the government’s financial report rocked UK pension funds, which accounted for more than £1 trillion in investments. The Bank of England stepped in, offering to buy bonds for two-and-a-half weeks to ease the funds’ liquidity problems and end a potentially catastrophic cycle of events that could involve a bond sell-off and risk shutting down a broader market ignite unrest.
But on Tuesday, as government bond yields started to rise again, Mr Bailey underscored that the asset purchase program would end on Friday as planned, shattering any hopes of an extension.
“My message to the funds involved and to all the firms involved in the management of these funds, you now have three days,” Mr. Bailey said Tuesday. “You have to get this right.”
The remark was planned to prompt a sort of showdown between the bank and the funds, unusual for traditionally cautious central bankers.
But Mr. Bailey made Friday a test not only of the progress of the pension fund industry but of himself. He could go by the bank’s decision and exit asset purchases as planned – a move that could allow him to focus more on inflation but risks a nasty market reaction. Or it could be softening now, extending support before it ends.
“It’s a bit of a gamble,” Professor Forbes said. “But there are good reasons why it should be short and limited, even if that makes it riskier.”
For one, the program is designed to help bond funds get the liquidity they need — not to stop bond yields from rising. Sticking to the deadline could force the funds to take advantage of the program now rather than wait for better prices later, and take losses on the leveraged trades that went wrong.
There are early signs the plan is working as the bank bought far more bonds than before on Wednesday and Thursday following Mr Bailey’s warning and interest rates fell.
Monday – the first day of trading after the end of the program – may not go smoothly for investors, but big moves in asset prices are bad only if they create systematic risk in financial markets, Professor Forbes said.
“Many companies will complain if they take losses,” she said. But “the Bank of England’s job isn’t to bail them out just because they’re suffering losses.”
Still, the bank was accused of being stingy with its initial bond-buying program, which forced it to expand later.
“The reason they have to play this whac-a-mole game,” said Antoine Bouvet, rates strategist at ING, is because “the intervention was inadequate from the start.”
Ed Al-Hussainy, a rates strategist at Columbia Threadneedle in New York, said the bank can’t follow the normal playbook for a crisis, which “dictates you have to come in with a sledgehammer, you have to drown the market in liquidity, and then you have you the opportunity to step back and find out what happened.”
Instead, the bank attempted to use a scalpel and take a more clinical approach. Even if it widened its intervention, the main component of the bond purchases would still end on Friday, the bank said. That firm deadline helped push bond yields back higher earlier this week.
Analysts argue the bank was placed in a relatively cautious position to avoid being accused of shielding the government from the market fallout of its actions.
When the bank’s staff took the sledgehammer approach, “they appear visually as if they are funding government spending,” Mr Al-Hussainy said. It’s a “credibility constraint.”
While the bank has been buying bonds, which usually result in lower interest rates, it also plans to raise interest rates higher to counter rising prices — including inflation that could result from the government’s tax cuts and spending plans.
At first glance, these guidelines appear contradictory, Mr Bouvet said. “It’s just the looks. And it clouds the water a little. That needs to be explained, but it’s not a contradiction.”
The confusion stems from the fact that the bank is using a familiar tool — buying bonds — for a different purpose. Between 2009 and 2021, the bank bought £895 billion worth of bonds for monetary policy objectives to keep interest rates low, a policy known as quantitative easing. This time it is offering to buy bonds (with no target amount) only in a segment of the bond market that is struggling in order to protect financial stability. The bank needs to convince the general public that this is not just more quantitative easing, which will benefit the government.
Communicating these policies is a tough policy, especially because government tax policies appear to be subject to change at any time as it fights for tax cuts and spending plans and debt reduction add up.
“It’s a broader credibility issue for the UK,” said Dean Turner, economist at UBS Wealth Management. “Overseas investors are looking to the UK right now and struggling to decipher what policy mix we’re going to get.”
Ultimately, markets – and by extension Mr Bailey – would need to be relieved of the burden of restoring Britain’s fiscal credibility, which only government can do. Meanwhile, analysts suggest Mr. Bailey could be forced into some sort of policy retreat, such as announcing a significant delay in a plan to sell government bonds from his holdings or expanding the current bond-buying operation in some way. After all, emergency operations usually take longer than originally expected.
“You should get a generous slice of this humble pie,” Mr Bouvet said. The central bank should “longer offer the market consolation and spend a lot of time explaining that this is not contrary to monetary policy”.
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