The Bank of England has announced it will embark on a government bond buying spree in a bid to stabilise the UK economy. The announcement follows days of turmoil, as the pound has slumped to record lows against the dollar in the wake of Kwasi Kwarteng’s mini budget.
Through a fiscal event packed with tax cuts and government borrowing commitments, the Chancellor had hoped to spark economic growth that would deal with the cost of living crisis and the threat of a recession in one swoop.
Things went from bad to worse for the government on Tuesday (27 September) when the International Monetary Fund (IMF) gave an unprecedented vote of no confidence in its plan for the UK economy.
So, what are government bonds - and what does the Bank of England’s announcement mean? Here’s what you need to know.
What are government bonds?
Every year, the government sets out how much money it will seek to raise from UK taxpayers in an event known as the budget. As we have seen with Rishi Sunak’s cost of living announcements earlier this year and Kwasi Kwarteng’s ‘mini budget’ last week, what was once an annual event is having its lines blurred.
The money raised through taxation is put towards government spending and public services. But if the state does not raise enough money to pay for its policy commitments - what is known as a budget deficit - it has to borrow money.
It does this by issuing government bonds - also known as gilts. These are loans lenders make to the issuer of the bonds (in this case, the government) and allows the issuer to raise money.
Usually, the private sector buys up government bonds as they are seen as stable investments that guarantee regular payouts - also known as yields.
These yields are connected to the price of the bond. So when the price of the bond falls (usually because the government is trying to borrow a lot of money), its yield will rise.
With the government set to issue lots of bonds as a result of its aggressive tax cutting, the yield on 10-year bonds has jumped to more than 4% - the highest level since the 2008 financial crash.
Given there are recessionary fears around the world - these events often mean lower tax receipts and therefore more government borrowing - the bonds market has been under pressure across the globe. But the UK government’s bonds have suffered more than most as a result of the market’s lack of confidence in Liz Truss’s economic plans, which have been branded as “unsustainable” by respected think tank the Institute for Fiscal Studies (IFS).
Ultimately, it all means the cost of borrowing is becoming more expensive for the government at a time when it needs to borrow more. The rise in yields in recent days may have added around £20 billion to the cost of servicing the UK national debt, experts have warned.
Should the UK accrue too much debt that it cannot pay off, it could lead to a default. Such a scenario would mean the UK economy becomes highly unattractive to the private sector, and would be likely to dent the country’s prosperity.
Why is Bank of England buying government bonds?
In a bid to stabilise the UK economy, the Bank of England - the UK’s central bank - has stepped in to buy government bonds. By doing so, it is essentially keeping a lid on the interest rate on public borrowing through quantitative easing - put simply, the printing of money.
This move has already helped bring down yields and has calmed the bond markets. It has also shown the Bank of England will intervene when necessary, after concerns were raised that it did not announce an emergency increase to interest rates in the wake of the fall in the pound.
But with the pound remaining low, and with the Truss administration sticking to its economic agenda, it might be forced to do more in the coming weeks and months.
Indeed, Fawad Razaqzada, a market analyst at City Index and Forex.com, suggested the situation could lead to more interest rate hikes from the Bank of England.
“The supply of pounds as a result of the Bank’s intervention will increase at a time when the Government has also announced a huge tax cutting bill. This will not help bring inflation down, but will have the opposite impact,” he said.
“Thus, the pound against the dollar could still be heading further lower.”
Additional reporting by PA