Recipe for Calming the Market: The Bank of England Temporarily Purchases Bonds Worth £65 Billion

To avoid a collapse in the British pension system, The Bank of England announced a bond purchase program worth £65 billion on Wednesday, all in an effort to halt the sovereign debt crisis, reports Reuters.

After the new British government presented plans on Friday to stimulate economic growth by reducing taxes and announced subsidies for household electricity and energy bills, which will be financed from a £45 billion debt, investors lost confidence in the stability of the United Kingdom, resulting in a record drop in the value of the British pound on Monday.

As reported by Business Insider, this also prompted an increase in yields on two-year government bonds to 4.3 percent, the highest level in 14 years, while the yield on ten-year bonds rose to 4.1 percent. A weaker pound makes imported goods more expensive, while higher yields on bonds increase the costs of sovereign debt. If yields rise further, the Bank explained that this could cause ‘unjustified tightening of financing conditions and a reduction in the flow of credit to the real sector.’ Simply put, higher yields on government bonds could lead to a credit crisis, making it more difficult and expensive for households and businesses to borrow money.

Due to the significant increase in yields on long-term government bonds, the Bank of England decided to intervene and temporarily buy long-term government bonds over a two-week period, from September 28 to October 14.

It was stated that they will purchase as many UK government bonds as necessary to stabilize the market, with costs covered by the government. They will spend £5 billion daily during these 13 days (excluding weekends) due to the ‘material risk to the financial stability of the United Kingdom’ and the threat to the pension system.

Risk of Increased Inflation

The temporary bond purchase is designed to calm investors and their fears that lower taxes and increased government spending will accelerate inflation, which is nearly at its highest level in four decades. This should prevent them from continuing to sell off bonds.

However, the government is printing money to buy bonds, thereby increasing the overall money supply in the market, which makes it less valuable and stimulates inflation. Nevertheless, the Bank of England believes that short-term bond purchases will not increase inflation but will calm the market. They also hope that such a move will prevent an even greater rise in bond yields, thereby preventing an increase in debt.

However, by purchasing bonds, they risk reducing inflation that has been spurred by recent increases in interest rates, which the International Monetary Fund has already warned the British government about. This could lead to the need for further increases in interest rates, thereby increasing the already significant fear of entering a recession. However, if the plan succeeds, it could prevent a credit crisis in the United Kingdom.