A Central Bank on the High Wire

https://www.nytimes.com/2022/10/13/business/bank-of-england-andrew-bailey.html

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Andrew Bailey is in an unenviable position. As governor of the Bank of England, he must rein in inflation, which is rising at the fastest pace in 40 years.

And now he must also clean up much of the early fallout from the policies of Liz Truss, the prime minister of Britain, and her fledgling government, whose tax-cutting fiscal agenda sent shock waves through Britain’s financial markets.

Mr. Bailey has a laundry list of challenges, including returning order to a dysfunctional bond market, stopping the turmoil in the pension fund industry from precipitating a full-blown financial crisis and protecting the central bank’s independence from the government.

Sitting atop the central bank, Mr. Bailey has to manage two tasks: keeping inflation low and stable and ensuring Britain’s financial stability. In the weeks since the government released its tax cut plan on Sept. 23, his efforts to do both have collided, leading to complicated and at times conflicting messaging, putting the 328-year-old bank’s credibility at risk.

“The Bank of England was in an incredibly tough situation before the fiscal news,” said Kristin Forbes, a professor of management and global economics at the Massachusetts Institute of Technology and a former member of the Bank of England’s rate-setting committee. “The U.K. was hit by the double whammy” of soaring energy prices caused by Russia’s war in Ukraine and an extremely tight labor market, “both of which are driving up inflation and will require monetary policy response and slower growth to get to equilibrium.”

“Then the fiscal announcement caused substantial concern,” she added.

The government’s policies have prompted warnings that fiscal policy shouldn’t undermine the efforts of central banks.

On Thursday, Kristalina Georgieva, the managing director of the International Monetary Fund, said the result would be higher interest rates and tighter financial conditions. “Don’t prolong the pain,” she advised at a news conference.

Fiscal policy should be led by evidence, she added, and if “there has to be a recalibration, it is right for governments to do so.” There were reports in Britain on Thursday that Ms. Truss might be considering a backtrack on some tax cuts, news the market took in stride, as the pound rose and bond yields fell on Thursday afternoon. On Friday markets continued to rally, which pushed bond yields down. The yield on the government’s 30-year bond fell as low as 4.3 percent in early trading, down from nearly 5.1 percent two days earlier.

The weeks of tumult in Britain’s markets and the risks posed by its fiscal policies are singular, but the challenge of setting economic policies when the options are constrained by the highest inflation in decades is a quandary shared by lawmakers and policy-setters around the world. Market volatility is high in many countries, and the temptation to spend heavily to protect households from the rising cost of living is strong. Keeping the right mix of spending to address inflation while not spooking investors is becoming harder.

It doesn’t help Mr. Bailey that he has been the subject of heavy criticism 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, with global financial markets in turmoil.

At the Bank of England, the clock is ticking on a potential flash point. The sudden jump in bond yields in late September after the government’s fiscal statement rocked Britain’s pension funds, representing more than a trillion pounds in investments. The Bank of England jumped in, offering to buy bonds for two and a half weeks to help ease the funds’ liquidity problems and put an end to a potentially catastrophic cycle of events, which could include a fire sale of bonds and risked sparking wider market unrest.

But on Tuesday, as government bond yields climbed again, Mr. Bailey underscored that the bond-buying program would end on Friday, as scheduled, scotching any hopes it would be extended.

“My message to the funds involved and all the firms involved in managing those funds: You’ve got three days left now,” Mr. Bailey said on Tuesday. “You’ve got to get this done.”

The remark was panned for setting up a sort of showdown between the bank and funds, unusual for traditionally circumspect central bankers.

But Mr. Bailey has made Friday a test not just for the progress of the pension funds industry but also for himself. He could stick by the bank’s decision and end the bond purchases as planned — a move that could allow him to focus more fully on inflation but risk a nasty market reaction. Or he could soften now and extend the support before it ends.

“It is a bit of a gamble,” Professor Forbes said. “But there are strong reasons why it should be short and limited, even though it does make it riskier.”

For one, the program is intended to help pension funds get liquidity they need — not to stop bond yields from rising. Sticking to the deadline could force the funds to use the program now rather than holding out for better prices later, and accept losses on the leveraged trades that went wrong.

There’s early evidence the plan has worked, as the bank bought far more bonds on Wednesday and Thursday after Mr. Bailey’s warning than it previously did, and rates have fallen.

Monday — the first trading day after the program is due to end — might not be smooth for investors, but big moves in asset prices are bad only if they lead to systematic risk in financial markets, Professor Forbes said.

“A lot of companies will complain when they take losses,” she said. But “the job of the Bank of England is not to bail them out just because they suffer losses.”

Still, the bank has been accused of being stingy in the initial bond-buying program, forcing it to later expand it.

“The reason why they have to play that game of Whac-a-Mole,” said Antoine Bouvet, an interest rates strategist at ING, is that “the intervention was insufficient to begin with.”

Ed Al-Hussainy, an interest rate strategist at Columbia Threadneedle in New York, said the bank couldn’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 the opportunity to step back and figure out what happened.”

Instead, the bank tried to use a scalpel and take a more clinical approach. Even as it expanded its intervention, the main bond-buying component would still end on Friday, the bank said. This fixed deadline helped push bond yields higher again earlier this week.

Analysts argue that the bank was cornered into a relatively cautious position because it wanted to avoid being accused of shielding the government from the market consequences of its actions.

If the bank’s staff took the sledgehammer approach, “they optically appear as if they’re funding government spending,” Mr. Al-Hussainy said. It’s a “credibility constraint.”

Indeed, while the bank has been buying bonds, which usually has the effect of lowering interest rates, it is also planning to lift interest rates higher to tackle rising prices — including the inflation that could stem from the government’s tax cuts and spending plans.

On the face of it, these policies seem contradictory, Mr. Bouvet said. “It’s just the optics of it. And it muddies the waters a little bit. It’s something that needs explaining, but it’s not a contradiction.”

The confusion comes 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 pounds of bonds for monetary policy goals to keep interest rates low, a policy known as quantitative easing. This time it’s offering to buy bonds (without a target amount) in just one segment of the bond market where there is trouble, in order to protect financial stability. The bank needs to convince the wider public that this is not simply more quantitative easing that will benefit the government.

It’s a challenging policy to communicate, especially because the government’s fiscal policies seem liable to change at any moment as it struggles to make tax cuts and as spending plans and debt reduction add up.

“It’s a wider credibility problem of the U.K.,” said Dean Turner, an economist at UBS Wealth Management. “Overseas investors are looking at the U.K. right now and struggling to decipher what policy mix we’re going to get.”

Ultimately, relief for markets — and therefore Mr. Bailey — would need to come from the restoration of Britain’s fiscal credibility, which only the government can deliver. In the meantime, analysts suggest that Mr. Bailey might be forced into some kind of policy retreat, such as announcing a significant delay in the plan to sell government bonds from its holdings or extending the current bond-buying operation in some way. After all, emergency interventions tend to last longer than initially expected.

“They should get themselves a generous slice of that humble pie,” Mr. Bouvet said. The central bank should “offer a comfort blanket to the market for longer and spend a lot of time explaining that it is not in contradiction with monetary policy.”