What is the Bank of England doing in bid to stabilise UK economy?

The Bank of England has intervened in an attempt to stabilise financial markets in the wake of steep falls in the pound against the dollar and a surge in the UK’s borrowing costs. The Bank said it was prompted to act by concerns about the impact these swings were having on pension funds. We explain what is happening.

What has the Bank done?

Officials at the Bank said they would effectively lend funds to the government to bring down the interest rates on government debt.

The government raises money by issuing IOUs, or bonds, which are bought up by investors on international money markets. It plans initially to spend £65bn – £5bn a day – buying UK bonds until mid October.

The measure is billed as temporary and targeted, but has already brought down the cost of borrowing for the UK government.

Why has it acted?

The central bank was worried that panic in financial markets was increasing the UK’s cost of borrowing at an alarming rate and hoped the announcement of its intention to intervene would bring some calm.

It is also expected that stability in the debt markets will have a steadying effect on the pound.

And it has given the prime minister and her chancellor some respite from a financial storm that threatens to wreck their plans to borrow billions to fund a £150bn energy price cap and tax cuts worth £45bn.

Markets reacted negatively to the tax plans, which many analysts said would fail to lift the UK’s long term growth prospects and add unwarranted sums to an already large and growing debt pile.

How does the Bank’s plan work?

The Bank’s intervention will help buy time for the pensions funds to unwind their derivatives positions.

If we consider the UK’s £2.2tn of government borrowing like a billion different mortgages, some of which last a few hours while others last 30 years, the Bank of England has said it is worried about the interest rate on refinancing the 10- to 30-year loans. The interest rate on longer dated loans has doubled in recent weeks.

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The loans are packaged as bonds and sold and resold on international markets. Anyone can buy a UK government bond and many of us will hold them indirectly in our pensions. In effect, we lend the government money by buying UK bonds.

Entering the market to buy bonds adds to the number of purchasers. An increase in the number of buyers pushes up the value. A higher value tells other potential buyers that the bonds are less risky to purchase, bringing down the interest rate.

Where does the Bank’s money come from?

At the moment the Bank owns £875bn of UK government bonds. It means the UK Treasury pays interest to the central bank.

The Bank has not paid for the bonds in cash, it has created the money with a guarantee from the Treasury, which means that every pound is covered by the taxpayer.

Financial markets understand that only a fraction of the bonds would ever fall due at any one time and so accepts the government guarantee as if it were gold-plated, or to use the age-old term for UK debt, gilt-edged.

The Bank called its bond buying programme quantitative easing. It had intended to reverse the process and start selling its UK bonds – unsurprisingly called quantitative tightening - but the recent developments means that process is most likely going to be put on hold.

Does sterling being a reserve currency make a difference?

The US dollar, the euro, the Japanese yen and the British pound are all widely traded and used to buy goods and services across the world, making them reserve currencies. If one of them becomes unstable because its value starts to plummet, as the pound has recently, the international authorities become worried.

It’s one reason why the International Monetary Fund said it was concerned about the UK government adding £45bn of tax cuts to £150bn of spending. With almost £200bn added to the UK’s debt pile over the next four years under this plan, investors were certain to sell the pound and demand the UK pay a higher interest rate on its loans.

The Washington-based IMF, which acts as the lender of last resort to country’s that cannot finance their debts, rebuked the UK for bringing instability to international money markets. It was also concerned about rising inequality, which has been shown to reduce productivity.

What happened in the pensions market?

The target of the Bank’s intervention was to prevent a “doom loop” of forced selling of UK government bonds by pension funds.

Many pension schemes have hedged against sudden movements in interest rates, using “liability driven investment” schemes (LDI). As much as £1tn is thought to have been invested in LDI schemes. To hedge, buyers pledge collateral – an asset accepted by the seller as security for the deal. In the case of the LDI schemes, this was UK government bonds with long terms of up to 30 years.

However, as bond interest rates rose sharply, the derivatives contracts required the pension funds to pledge more collateral. After using up existing cash reserves, the funds sold off bonds to meet their obligations. This put more bonds into circulation, at a time when others were also trying to sell, putting further selling pressure on bondinterest rates, and worsening the doom loop.

Pensions funds were facing margin calls – demands for more collateral – of up to £100m each, according to the financial trade magazine Risk. It is understood some came close to running out of cash.

Can buying more bonds help?

For a short time, yes. Interest rates on government debt fell on Wednesday after the Bank intervened, with the 30-year bond rate moving from above 5% to below 4%. The current bond-buying programme runs until 14 October, and may be enough to calm the waters until then. But the chancellor needs to revise his tax-cutting plans within the next fortnight or risk markets returning to the panicked selling seen earlier in the week.