Andrew Bailey took the gamble of his career on a sunny Tuesday afternoon in Washington, when speaking to bankers at the Institute of International Finance.
Amid all the turmoil following chancellor Kwasi Kwarteng’s “mini” Budget, the BoE governor decided to use his appearance at the financial industry representative body to play a game of chicken with the markets.
Bailey ruled out extending the central bank’s emergency programme to buy UK government bonds, which was launched when a sharp spike in gilt yields after Kwarteng’s fiscal statement threatened insolvency for multiple pension schemes.
He had a tough message for the pensions industry, telling it to sort out its problems ahead of the programme’s scheduled expiry on Friday. “You’ve got three days left, now. You’ve got to get this done,” said Bailey.
Before this well-rehearsed soundbite, Bailey explained why he was taking such a hardline stance.
The world was not like the early stages of the Covid-19 pandemic, when the BoE printed money in great quantities, bought assets at almost any price, cut interest rates and put no time limit on the intervention, he insisted.
“We’ve got two things going in opposite directions,” he said of the current situation, citing the dual pressures on the BoE to both tighten monetary policy to curb high inflation as well take steps to restore order in the government bond market.
“We were going to start [quantitative] tightening and we were raising interest rates, at the same time as we are having to offer to buy gilts,” said Bailey. These contradictory pressures justified the time limit on the BoE financial stability operation, he suggested.
BoE insiders are in no doubt the central bank and the governor are caught in a very difficult situation, saying it was created by the government’s £43bn of unfunded tax cuts contained in the mini Budget, which spooked the markets.
They hope the Friday deadline for conclusion of the central bank’s gilt-buying operation will galvanise minds at pension funds and offer everyone a way out, but there are three main risks the BoE is facing.
The first risk comes from mixed messages. The Financial Times reported on Wednesday that BoE representatives had informed some banks that it was prepared to extend the bond-buying facility beyond October 14 if market conditions demanded it, citing people briefed on the discussions.
The BoE subsequently issued a statement saying its “temporary and targeted purchases of gilts will end on October 14”, adding this had been made clear to banks “at senior levels”.
One industry person involved in the discussions between BoE representatives and the banks said later: “While [the BoE said] that banks had been told at a senior level that the programme would stop on Friday . . . we were also being told that they would do whatever it takes to stop this from becoming a systemic crisis and would consider extending it. Both of those statements are probably true.”
Former BoE officials said it was reasonable for banks to think the central bank’s bond-buying programme could be extended.
Sir Charlie Bean, former BoE deputy governor, said “if after the end of the week, financial stability risks [are still there], the bank will have to step in again”.
Since Bailey cannot guarantee the BoE bond-buying operation will end on Friday and knows that in a stressed situation he will not have any choice but to retain the facility, it was quite a gamble to send such a tough message to pension funds and their liability-driven investment providers. It might backfire.
The second risk for Bailey and the BoE is the prospect of tensions with the government following a short period when Kwarteng has acknowledged the virtues of economic orthodoxy and said how much he values the independent central bank.
Chris Philp, chief secretary to the Treasury, said on Wednesday he had “complete confidence in [BoE officials’] ability to manage systemic financial stability”, but other ministers were less generous.
Jacob Rees-Mogg, business secretary, blamed the BoE for market turbulence, suggesting it had been caused by the central bank’s failure to raise interest rates as quickly as the US Federal Reserve.
The problems were “much more to do with interest rates than it is to do with a minor part of fiscal policy”, he added.
BoE insiders reject this view and see themselves as stuck dealing with a mess not of their own making.
They agree with the IMF that the government’s loose fiscal policy has been working “at cross purposes” with their battle to bring down inflation.
According to Bean, Kwarteng’s unfunded tax cuts mean the BoE cannot be seen to be subsidising government borrowing costs or “doing anything that would be interpreted as helping government out of a hole”.
Lowering borrowing costs for governments that have unsustainable fiscal policies has traditionally been the route towards hyperinflation.
If these two risks were not difficult enough, a third is a simmering difficulty within the BoE itself, involving its two roles to maintain financial stability and to set monetary policy.
Bailey highlighted how the two areas of policymaking were pulling in different directions on Tuesday.
Others have a different interpretation, with Huw Pill, BoE chief economist, suggesting on Wednesday the two policies were complementing each other.
“Restoring market functioning,” he said, using the bond-buying intervention, “helps reduce any risks from contagion to credit conditions for UK households and businesses [and] such actions preserve the effective transmission of monetary policy”.
His reassuring words apply only if the BoE actions to lower gilt yields are temporary, however.
If they were permanent, as Bailey explained, monetary policy would not be able to function properly to set a sufficiently high interest rate to control inflation.
Taking these three risks together, many things could go wrong for Bailey in the next few days as he deals with the possibility of the markets calling his bluff.
If the BoE has to resume buying government bonds after Friday to restore calm, his credibility will be severely damaged.
The one piece of good news for the governor, however, is that this is exactly what happened to Lord Mervyn King in 2007.
The then BoE governor wrote a letter to the House of Commons Treasury committee saying that any bailout of Northern Rock would commit the sin of encouraging moral hazard, only to eat his words a few days later when a run on the bank started.
Despite that disaster, King remained governor until his term expired in 2013.
Additional reporting by Owen Walker in London
