The Banker and Bailey Circus

Governor of the Bank of England, Andrew Bailey, speaks to the media about the monetary policy report, London, 4 August.


Photo:

yui mok/Agence France-Presse/Getty Images

The Bank of England’s decision on Wednesday to buy UK bonds is being portrayed as a rebuke of new Prime Minister Liz Truss’s economic program, and BOE Governor Andrew Bailey may have meant it. The intervention calmed bond and equity markets, at least for now, but at the cost of showing once again that central bankers are easily spooked into bailout mode.

Investors are cheering their success in luring the Bank of England back into the market to underwrite bond prices. On Monday, the BOE issued a statement saying it would evaluate market movements “at its next scheduled meeting,” which is in November. Two days later, it had forgotten all about that, saying it would “make temporary purchases” of longer-term gilts “to restore orderly market conditions.”

The reason for the market disruption is reportedly the Truss government’s proposals for new tax cuts and spending to ease the burden of rising energy prices. It’s a convenient scapegoat for Mr Bailey and other central bankers, but that’s not the half of it.

Markets started to head south last week when the Federal Reserve raised interest rates by 75 basis points again, signaling that more hikes are on the way to combat inflation. Mr. Bailey’s BOE followed by raising its target rate by just 50 basis points.

The various central bank moves widened the gap in monetary policy tightening that has pushed the dollar to new highs against nearly all the world’s currencies. The Chinese yuan fell to its lowest against the dollar on Wednesday, 7.2 per buck, since 2008. The euro is now below parity with the dollar.

Central bankers have abandoned monetary policy coordination, so investors bet on (and contribute to) rapid exchange rate changes while playing the political margins. This uncertainty is detrimental to investment and trade flows, and it also contributes to erratic market movements that catch some investors stranded. Ditto for sharp moves in bond prices as the 10-year UK gilt hit above 4.5%. On September 22, it was 3.3%.

Amid this turmoil, markets understandably loved the BOE’s intervention, and the contention is that the central bank moved in part because large UK pension funds and financial institutions were caught on the wrong side of these rapid shifts in market prices. We cannot judge without knowing the details.

But there is no doubt that the BOE’s intervention has now made the bank work at cross-purposes with its monetary mission. The BOE’s monetary policy committee wants to tighten policy to break inflation. At its last meeting, it said it would sell down its quantitative easing bond portfolio. But the BOE’s fiscal policy committee is now buying bonds to ease financial conditions. This cannot help the BOE’s credibility as it navigates the bumpy road away from the historic monetary mistakes that have produced our current inflation.

This is one of the reasons why it is a mistake to mock Mrs Truss and the British from the American cheap seats. There, but for the relative strength of the dollar, we go. For all the worry about UK debt, the UK’s overall debt to GDP ratio (86%) is lower than that of the US (127.5%) and its interest expenditure as a share of GDP is lower. The American saving grace is the dollar’s status as a global reserve currency.

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The bigger story here goes back to the mistakes of the Fed and other central banks in letting policy run amok and then dismissing the signs of emerging inflation as “transient.” Too many investors began to believe the Fed’s advertising, believing that money would be risk-free forever. They made bets that made sense at near-zero interest rates, but look much uglier when fed funds are headed for 4% and maybe 5% or higher.

The big surprise so far during this big monetary correction has been the lack of a big economic loss. There has been no Orange County (1994), no Long Term Asset Management (1998) and no Fannie Mae (2008). But then again, maybe the panic in the British pound and bonds is a sign of things to come.

A policy response would be for the major central banks to start coordinating again to reduce uncertainty and volatility. The Fed may also reopen dollar swap lines to help other economies with liquidity as the dollar continues to rise. The hard truth is that correcting for the inflationary blunder would always be painful, and that’s what the banker and the Bailey circus tell us.

Review and Outlook: British Prime Minister Liz Truss’s fight for economic growth has begun, after years of outdated Keynesian policy consensus that has produced stagflation everywhere. Images: Zuma Press/PA Images via Getty Images Compiled: Mark Kelly

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Published in the print edition on September 29, 2022.

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