It’s fair to say the UK economy has been a bit all over the place since Friday.
The pound tumbled in value on Monday, bounced back a little on Tuesday, only for the Bank of England to make a dramatic intervention on Wednesday.
The flurry of events can be hard to follow.
In a nutshell, it kicked off when chancellor Kwasi Kwarteng unveiled his deeply divisive tax cuts in his mini budget. The Bank of England – which has to control the country’s inflation rates – has announced a series of important measures in a bid to control the turmoil seen in the UK market since.
The intervention is seen as a sign of just how worrying the state of the economy is right now. So, here’s what you need to know.
What did the Bank of England just announce?
It will buy government bonds (temporarily)
The Bank announced on Wednesday that it would buy government bonds (otherwise known as gilts) on a temporarily basis, to bring order back into the market.
These bonds are essentially an “IOU” with interest, a promise to pay someone back in the future. Effectively, the Bank is buying unlimited amounts of long-term debt.
So, the Bank is buying an unlimited amount of these bonds from the government (because no one else on the market wants to buy from the UK right now) putting more money back into the economy.
With more money circulating within the UK as a result, the cost of money is reduced (because it’s not as hard to come by), thereby bringing inflation back down.
This is a form of quantitive easing, where a body (the Bank) increases the supply of money within an economy by buying financial assets.
Prior to this emergency intervention, the Bank was actually planning on selling off debt – meaning markets could become confused about what policies the Bank is sticking with.
Interest rates expected to increase, too
Although this detail has not been confirmed yet, the Bank of England is expected to increase interest rates in order to bring inflation down to its target 2% level.
The Bank has already said it will not “hesitate” to increase interest rates to protect the pound.
Interest rates reflect how much interest people receive on their savings, or how much they pay on their loans.
This has the knock-on effect of changing how much people spend in the economy, helping either encourage or discourage inflation.
After the global financial crisis of 2008, the bank rate has been much lower – it was immediately cut from 5% to 0.5% – but. forecasters think it could climb from the current level of 2.25% to 5.8% next spring.
What happened after the Bank’s announcement?
The pound fell to $1.0560 after the Bank’s intervention, down 1.6% against the US dollar.
But, interest rates being charged to the UK government in these markets were soaring to 20-year-highs before, but fell back after the news.
So, as the BBC’s Faisal Islam noted, this news “might buy the government some time” but does not fix the damage from the mini-budget.
Why did the Bank of England intervene?
The mini-budget
Kwarteng’s £45billion worth of unfunded tax cuts was unveiled on Friday, in his “mini” budget although, by all accounts, it was pretty large.
It did not come with an independent assessment of the UK’s economy from the Office of Budget Responsibility, as regular budgets do.
International markets reacted – badly
Investors were not pleased by Kwarteng’s huge cuts. They thought the UK will probably have to borrow to make up for the tax cuts, increasing national debt, meaning they started to pull their funds out of UK business.
Kwarteng then hints at more cuts to come over the weekend, adding more turmoil to the market.
The pound tumbled
On Monday, Asian markets react and the pound falls to $1.03 in value – its lowest ever value. European markets then restore a little faith in the following hours, and it bounces back to $1.085. The government refused to comment on such market fluctuations.
Widespread backlash to the budget
Kwarteng and Liz Truss were left red-faced after a dressing down from the International Monetary Fund (IMF) where Downing Street was accused of undermining the Bank of England’s efforts to control inflation, through the tax cuts which would “likely increase inequality”.
This criticism alone brought the pound down to $1.06 in value.
Credit rating agency, Moody, one of the most influential adjudicators, also criticised the tax cuts, claiming it could “permanently weaken the UK’s debt affordability”.
The US also warned that it was monitoring the UK market “very closely”.
Mortgages products were then taken off the market at an unprecedented level, and pension funds (which had lent money to the government) were asking for them to be returned.
So – are we now in a financial crisis?
Essentially, the UK’s market has taken a blow to its reputation, but it has (just) sidestepped a financial crisis.
There are fears that the pound could reach parity with the US dollar, which has never happened before unless Downing Street undoes parts of its mini budget – but the Bank has given the government some breathing space.
As Capital Economics economist Paul Dales told the BBC: “This shows that the Bank is going to do all it can to prevent a financial crisis and it is already working.While this is welcome, the fact that it needed to be done in the first place shows that the UK markets are in a perilous position.”
Chief executive of the Resolution Foundation think tank, Torsten Bell, said it was “nuts” that the Bank even had to intervene at all.
The chancellor is meeting with investment banks on Wednesday, after defiantly defending the tax cuts.
Meanwhile, the Labour Party has not missed a beat. The party pointed out “the market’s in freefall” under the Conservative leadership, while SNP leader and Scotland’s first minister Nicola Sturgeon is calling for MPs to head back to the Commons as soon as possible along with Labour leader Keir Starmer.
Has this happened before?
In 1976, the UK did actually experience a similar crisis as budget deficits triggered the value of the sterling to plummet adding to already high-inflation rates.
At the time, the government had to ask the IMF for a loan, in exchange for reducing public spending.
Now, the Bank of England is a more established institution, and can act on its own accord to adjust inflation.