Liz Truss against the Bank of England by Shang-Jin Wei

The Bank of England’s recent intervention in the UK government bond market may have averted a financial crisis, but it will also fuel inflationary pressures. Prime Minister Liz Truss must reverse her tax cuts and introduce policies to help struggling homeowners, allowing the BOE to focus on restoring price stability.

NEW YORK – After a week of turmoil in financial markets, British Prime Minister Liz Truss has been forced to abandon plans to abolish the top 45% tax rate for high earners. The U-turn, an attempt to counter a market sell-off that caused the pound to crash and saw the Bank of England launch a massive bond-buying program to prevent ‘a significant risk to financial stability of the United Kingdom”, is a necessary first step. towards stabilizing the economy. But unless Truss rolls back further tax cuts or introduces policies to protect retirees and help struggling mortgage borrowers, the market turmoil won’t end anytime soon. In fact, it could get worse.

The ‘mini-budget’ that Truss and Chancellor of the Exchequer Kwasi Kwarteng proposed late last month, which includes sweeping tax cuts for businesses and the wealthy, would likely lead to increased demand on the scale of the economy, further exacerbating the overheating of the British economy. and push up the already high rate of inflation. UK gilt prices fell during the week of September 23-27 as investors expected the BOE to offset inflationary pressures by raising interest rates faster than it had expected.

But instead of selling bonds, the BOE started buying gilts to push down the interest rate. What explains this maneuver? Government bonds are a key component of many pension fund portfolios and in recent years many UK pension funds have used so-called liability-driven investment strategies to hedge against risk. As UK government bond yields soared, pension funds struggled to meet demands for collateral. The BOE’s attempt to stabilize the price of long-term bonds was therefore aimed at preventing the fallout on the pension sector from spreading and causing an outright financial meltdown.

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