(Bloomberg) -- Last week, the Bank of England was confronted with a nightmare scenario it had long feared. A corner of UK financial markets faced a liquidity crunch at a time of soaring inflation and all the BOE could do in response was buy government debt.
The £65 billion ($72 billion) pledge staunched the crisis but it threw the central bank into a contradictory policy position, one it may be confronted with again over time.
The problem is that to deal with the market fallout from the government’s unfunded tax-cutting plan, it’s buying gilts, the first time it has done so on financial stability grounds. At the same time, its inflation-fighting mission means it’s raising interest rates and preparing to sell gilts from the separate £875 billion quantitative easing portfolio.
The combination, through which the central bank appears to be both loosening and tightening simultaneously, has blurred the lines between monetary policy and financial stability.
More fundamentally, it has exposed the institution to accusations of monetary financing -- the controversial idea that the BOE is bankrolling the government.
While the central bank has long been aware that it might need a formal tool to address a market disruption, the ferocity of the recent bond selloff, and its impact on pension funds, meant officials were forced to push it through before the usual consultation process.
Lying behind all this is the new job the BOE has given itself. It has become a “market maker of last resort” for government debt, a role it was too scared to embrace over the past decade on concerns it could look like a formal deficit financing tool. If ever the government failed to get a debt issue away, the thinking went, the BOE would be there.
The issue is even more pronounced now that the new government of Prime Minister Liz Truss is testing the boundaries of UK credibility with its fiscal plans and attacks on institutions like the BOE, shaking investor sentiment.
Robert Gilhooly, senior economist at asset manager abrdn, has warned the intervention “raises the spectre of monetary financing.” Gilles Moec, chief economist at AXA Investment Managers, said there’s a “distinct risk” it comes to be seen as “another step into fiscal dominance,” implying a threat to BOE independence.
The BOE is acutely aware of the concerns. In a letter published Oct. 6, Deputy Governor Jon Cunliffe stressed that the “temporary and targeted” operation was “not intended to create central bank money on a lasting basis” or be seen as yield curve control.
However, Anne Sibert, a professor at Birkbeck, University of London, who first proposed the MMLR tool in 2007, said the current arrangements do make it “expansionary monetary policy -- or QE” because the BOE is enlarging the money supply to buy gilts, just as it did during the pandemic.
So far, though, the sums involved have been tiny -- less than £4 billion -- as the intervention has stabilized markets without the need for vast purchases.
‘Hit and Hope’
The last time the BOE used bond purchases are a market stabilizing tool was in the early days of the pandemic in 2020.
Governor Andrew Bailey later described that £200 billion stimulus as hit and hope -- a “very big QE operation to hit the market with liquidity and hope it would get to the parts that needed it.” Andrew Hauser, executive director for markets, described it as the BOE acting as the “buyer of last resort.”
At the time, inflation was plunging and the bank was cutting interest rates. Buying gilts to stabilize markets was aligned with monetary loosening. Today, with inflation at a four-decade high and rates rising, the policies are in conflict.
Back in 2020, BOE officials knew they were storing up problems. Hauser would acknowledge in a speech the following year that “in different circumstances, the optimal policy response for the two goals could diverge.”
One former official involved in the March 2020 decision told Bloomberg that policymakers would have liked different tools to clarify matters but, with only a few hours to craft an emergency response, they were out of time.
The person, who declined to be identified, said one idea proposed was “Blue QE” for monetary policy and “Red QE” for financial stability.
Last Wednesday, the BOE effectively launched “Red QE” -- MMLR for government bonds, forcing an issue that it has been avoiding for years.
MMLR is not a new tool. It was first proposed to prevent markets running out of liquidity in the 2007 credit crunch by Sibert and her husband Willem Buiter, a former BOE rate setter. The BOE used it in 2009 for corporate bonds to ensure business could access finance.
In a 2012 review of the BOE’s liquidity facilities, Bill Winters, now Standard Chartered Plc chief executive, called for a permanent facility but it never materialized. The issue reared up again in 2015 when then-Governor Mark Carney described MMLR as the “third line of defence” against a liquidity crunch in the gilt market.
According to one government official involved in subsequent discussions, Carney’s comments caused irritation in government on fears the tool would look like a monetary financing guarantee -- a promise to buy gilts if no one else would -- that might destroy the central bank’s institutional credibility.
As the BOE dithered, finance continued to migrate from the regulated banking sector to the lightly regulated non-bank financial institutions, the collection of asset managers known as “shadow banks.” Between 2008 and 2020, non-banks more than doubled in size, compared with 60% growth for the banking sector, according to the BOE.
As a result, the need for an MMLR tool, the market equivalent of the “lender of last resort” facility used to rescue Northern Rock and Royal Bank of Scotland in the financial crisis, has grown more pressing.
The UK’s latest financial crisis has pushed the BOE down that path, one it knew was coming eventually. The difference is that, unlike the financial crisis after which banks faced strict regulations in return for a bailout, there is no quid pro quo for supporting shadow banks and entire markets with liquidity.
The BOE’s hand was forced. It had no time to set conditions, and the alternative to a bailout was worse.
“Action was unavoidable with a systemic crisis emerging in the UK pension industry,” said Moec at AXA. “But choosing bond purchases rather than channelling liquidity to pension funds -- although operationally expedient -- puts the Bank of England in a delicate position.”
©2022 Bloomberg L.P.
Advertisement