Liz Truss vs. the Bank of England

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 fullblown financial meltdown.

But the BOE most likely has another motive for intervening in the government-bond market. Unlike the US housing market, where 15-30-year fixed-rate mortgages are common, many UK homeowners have floating-rate mortgages.

About one-third of the country’s mortgages are on fixed rates that will expire in the coming two years. This means that any interest-rate increase would raise the monthly mortgage payments of many British homeowners immediately or very soon.

It would also make mortgages less affordable, driving many prospective home buyers to put off buying a house. So, the BOE’s intervention may have prevented a mortgage-market meltdown and a housing market crisis at the same time.

But it will also boost inflation. US President Ronald Reagan’s tax cuts in the early 1980s – an inspiration for Truss and Kwarteng’s program – generated upward pressure on prices, but the effect on inflation was offset by the Federal Reserve’s decision to sell US Treasuries rather than buy them.

The BOE’s bond-buying program, on the other hand, will add fuel to the inflationary fire.

Given the BOE’s inflation-fighting mandate, it is reasonable to expect that it would look for ways to undo or at least mitigate the impact of its intervention. But monetary policymakers are stuck between a rock and a hard place.

They can either raise the interest rate to fight inflation – thereby tolerating falling bond prices and risking mortgage troubles – or lower the interest rate to bail out mortgage borrowers and bond investors and accept rising inflation.

Truss can and must help the BOE find a way out of this conundrum.

Given that she has demonstrated a willingness to increase government borrowing to pay for a two-year cap on household energy payments, she could also introduce a two-year cap on household mortgage payments and add protections for pensioners.

To be sure, price caps are not the most effective way to deal with either skyrocketing energy bills or higher mortgage payments. But if the government is willing to cap households’ energy payments, it might as well cap mortgage payments, too, since both have the same “popularist” logic. Yes, doing so would increase the deficit – but it would also allow the BOE to focus on fighting inflation without worrying too much about pension and mortgage crises.

The best way the government can stabilize the UK economy and fight inflation, however, is to reverse more of the planned tax cuts, replace the energy-price cap with a fixed subsidy per household, and implement most of the spending cuts it announced.

The UK’s corporate and personal income tax rates were among the lowest in the OECD even before Truss and Kwarteng’s budget plan, so it is hard to make the case that substantial tax cuts are required to make the UK more competitive.

Moreover, providing a fixed energy subsidy instead of an energy cap would require a smaller government expenditure to provide the same amount of help to lowerincome households, provide an incentive to save energy, and reduce the overall cost of energy-price relief.

The combination of spending cuts and reversal of some of the announced tax cuts would have an inflationreducing effect akin to an interest-rate increase. That would make it easier for the BOE to tame inflation with a smaller increase in the interest rate.

And by facilitating the task of lowering inflation, the UK government could also make the pound more attractive to currency traders, potentially reversing some of sterling’s recent declines.

Shang-Jin Wei, a former chief economist at the Asian Development Bank, is Professor of Finance and Economics at Columbia Business School and Columbia University’s School of International and Public Affairs.