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Liz Truss vs. the Bank of England

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

NEW YORK – Following a week of financial-market turbulence, UK Prime Minister Liz Truss was forced to scrap her plan to abolish the 45% top income-tax rate for high earners. This U-turn, an attempt to counter a stunning market sell-off that caused the pound to crash and saw the Bank of England launch a massive bond-buying program to prevent “material risk to UK financial stability,” is a necessary first step toward stabilizing the economy. But unless Truss reverses more of the tax cuts or introduces policies to protect pensioners and help struggling mortgage borrowers, the market turmoil will not end soon. In fact, it could get worse.

The “mini-budget” that Truss and Chancellor of the Exchequer Kwasi Kwarteng proposed at the end of last month, which includes sweeping tax cuts for corporations and the rich, would likely cause an economy-wide surge in demand, further overheating the UK economy and pushing up the already-high inflation rate. The prices of British gilts 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 planned.

But instead of selling bonds, the BOE began buying gilts to push down the interest rate. What explains this maneuver? Government bonds are a key part of many pension-fund portfolios, and in recent years, many UK pension funds used so-called liability-driven investment strategies to hedge against risks. As yields on UK government bonds soared, pension funds struggled to meet collateral requests. The BOE’s attempt to stabilize the price of long-term bonds was thus meant to prevent the fallout in the pensions sector from spilling over and causing a full-blown financial meltdown.

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