BOE's stance against to Pound and rate increase options

BoE statement  The Bank of England and the UK Treasury have failed in a joint bid to calm financial markets as investors will have to wait until November for a broader policy response to the effects of the new government's massive tax cuts.

After a day when the pound slumped to a record low against the dollar and gilt yields soared, speculation was common that the UK would launch a stronger response, possibly including emergency rate hikes, to stem the decline. Instead, another round of selling hit the pound after a BOE announcement, which came about 14 hours after the pound slump.

BOE fails to calm market nerves.  Pound fell after announcement but remains above record low.

Strong expectations had led to a rebound in the sterling, but BOE Chairman Andrew Bailey said the bank was only watching developments in financial markets 'very closely' and that policymakers would 'not hesitate to change interest rates': 'It is necessary to return inflation to the 2% target in a sustainable manner over the medium term. ”

“Taken with the massive and sustained negative market response to the mini-budget, particularly the declining pound, the central bank's November forecast is likely to show significantly more inflationary pressure over the medium term. We think this will force the BOE to raise 100 basis points at its next scheduled meeting.'

— Dan Hanson, senior UK economist

Several days of pound fluctuation  The BOE's statement comes minutes after Finance Minister Kwasi Kwarteng tried to reassure markets about its economic strategy and promised to release a medium-term fiscal plan on November 23 alongside a forecast by the government's budget watchdog. Kwarteng, like Prime Minister Liz Truss, has only been in office since early September, during which time the sterling has fallen more than 7% against the dollar.

The pound was down 1.8% to trade at $1.0663 at 16:47. In London, it previously dropped to $1,0350. In the UK, 10-year gilt rates increased by 42 basis points to 4.24%, the highest closing since 2008.

“Markets are disappointed,” said Valentin Marinov, strategist at Credit Agricole FX. “If the selloff continues and say the pound starts flirting with the dollar in the coming days, the BOE will have no choice but to take up arms and try to support the pound.”

The problem is that their options are limited. Rate hikes alone may not be enough and could ultimately damage the economy even more, and the BOE's foreign exchange reserves are not deep enough to take over the markets.

Interim or aggressive rate hike  Raphael Bostic, the US Federal Reserve official, said that market movements could cause more economic stress in Europe and the United States, while analysts and investors said that the government is making minimal efforts to ease the markets.

'There seems to be no reason to believe that markets will give the government the advantage of doubt ahead of Kwasi Kwarteng's new fiscal plan,' said Chris Scicluna, head of economic research at Daiwa Capital Markets.

'The market may push its hand and there may still be an urgent rate hike ahead of the next BoE meeting,' he said, referring to the next scheduled policy announcement on Nov.

Gilt yields showed little reaction to the BoE and government statements, but very short interest rate swaps lessened the possibility of an immediate rate hike next week.

Mohamed El-Erian, Allianz's chief economic adviser, had previously said that if Truss and Kwarteng did not back down, the central bank would have no choice but to raise interest rates.

'No less, 100 basis points, a full percentage point to stabilize the situation,' he told BBC Radio.

The tough decision between rising cost of living  The move by the Bank of England Monetary Policy Committee, or MPC, was aimed at cooling widespread inflation triggered by rapidly rising fuel prices and global famines that created a cost of living crisis in the UK.

James Smith, economist at Dutch multinational banking and financial services firm ING, said the increase 'shows not only how concerned policymakers are about the decline in sterling and other UK markets, but also how the government's decision to limit household/business energy prices will look like'.

Inflation in the UK is at 9.9% – the highest rate in 40 years – and experts believe it could even reach 13% by the end of the year if effective action is not taken.

Increases in interest rates are effective in cooling inflation, but they are not without risk. They are also raising the price of mortgages and lines of credit, which could leave millions of British households worse off. It also encourages people to save rather than spend, which strains the manufacturing and service industries.

Conclusion?  The wild market swings of recent days are a response to Truss' 'Growth Plan' - the biggest tax gift in half a century - that investors fear will fuel inflation and increase borrowing at a time when interest rates are skyrocketing. Markets rallied after Friday's financial announcement, and the frenzy continued into the new week after Kwarteng said he was considering reducing taxes again next year.

A continuing rout risks undermining credibility in the UK and also affecting the real economy, while the Resolution Foundation warns that British households will become poorer as a result of the chaos.

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