Nine days into the Bank of England’s 13-day operation to calm markets and create an escape chute for overleveraged pension funds, fresh storms should not be breaking out. But they are. Index-linked gilts have been added to the list of things the Bank is prepared to buy – on top of the conventional long-dated variety that have been the focus so far. This wasn’t just a technical tweak. The dreaded phrase “a material risk to financial stability” has returned to official communication.
What happened? First, the mini drama with pension funds’ liability-driven investment strategies. Despite Threadneedle Street’s loose claim that LDI funds have made “substantial progress” in deleveraging themselves, it rather looks as if some funds failed to heed the official warning to get their houses in order.
Maybe a few were gambling that the Bank would roll out its full £65bn arsenal for the 13-day operation and force gilt yields lower, which would deliver better prices for the sellers. So far, that’s been a losing bet for the funds. Yields have returned to alarmingly high levels – 4.7% on the 30-year variety, so not far off the 5% seen before the Bank’s original intervention, which was triggered, of course, by Kwasi Kwarteng’s mini-budget on 23 September.
The Bank’s latest intervention illustrates what a narrow path it is having to tread. It can allow yields to rise a bit (it’s not targeting a particular level, remember), but it cannot allow complete chaos to reign. Thus the move on the “linkers”. It is a high-wire act.
But the market’s revolt over Kwarteng’s tax and spending plans never went away. Investors do not see the chancellor’s tax giveaways as credible; they do not think he will find sufficient spending savings to be able to claim “fiscal responsibility” with a straight face; and they agree with the International Monetary Fund that the government’s plans are undermining the Bank’s inflation-fighting job.
There are only two real ways out of the bind. Kwarteng could prove everybody wrong on 31 October, the date of his next fiscal event, and produce deep cuts in government spending to make the numbers add up. But, given that the Institute for Fiscal Studies thinks £60bn-worth of savings would be required by 2026, the bar is set high and may be politically impossible to clear. Alternatively, Kwarteng can perform another U-turn and reverse more of his tax cuts. The act might be terminal for his chancellorship, but it would be the quickest way out of this crisis.
Sympathy, then, lies with the Bank (with the important proviso that it should have spotted the LDI timebomb years ago). It is attempting to maintain order in markets with a series of temporary monetary interventions when the only true remedy can be provided by the chancellor in fiscal form.
At the margin, the Bank could help itself by saying it will postpone (again) its plan to start quantitative tightening – in other words, selling gilts rather than buying them – at the end of the month. Ultimately, though, the market turmoil is the government’s problem. The daily frenzies will stop when it steps back from its reckless fiscal plans.
Pick your own energy revenue reforms
After all the angst, the government still hasn’t definitely solved the great puzzle of how to tax the windfall gains of renewable electricity generators. A “cost-plus” revenue limit will be introduced from the start of the next year, but important details are yet to be decided.
What, for example, is “an appropriate revenue that reflects their [generators’] operational output, investment commitment and risk profile”? The only hint was that those companies producing baseload supplies, meaning nuclear and biomass, could get more favourable terms.
Meanwhile, the idea of switching relevant generators on to contracts-for-differences (a less problematic formula since revenues above a “strike” price already flow to the Treasury) has been retained as an option. It looks a case of inviting companies to choose which reform they prefer. From their point of view, it could have been worse.
