Amid the political turmoil of outgoing British Prime Minister Liz Truss’s
short-lived government, the Bank of England has found itself in the
fiscal-financial crossfire. Whatever government comes next, it is vital
that the BOE learns the right lessons.

On September 23, Truss’s government announced a large, unfunded
fiscal-stimulus package that undermined the BOE’s price-stability mandate
and caused government-debt and foreign-exchange markets to malfunction.
To prevent systemically important markets from seizing up, the BOE
postponed its planned offloading of government bonds (gilts) and instead
purchased more. But these unsterilized (monetized) asset purchases amount
to an expansionary monetary policy, which will further frustrate the BOE’s
efforts to bring down inflation – unless and until the purchases are
reversed.

Unfortunately for the BOE, it had no choice. Financial stability is a
precondition for sustainable price stability, so it is a central bank’s
overriding concern. When the circumstances demand it, central banks must
act as lenders of last resort (LOLR) to preserve or restore funding
liquidity for systemically important counterparties. They also must
serve as market makers of last resort (MMLR) or buyers of last resort
(BOLR) to maintain or restore market liquidity in systemically important
financial markets.

The BOE got its latest interventions partly right, but it also made
mistakes. When market participants in the UK – notably liability-driven
investment (LDI) funds – panicked, the BOE intervened, on September 28,
with a powerful statement about its willingness and ability to act.
Purchases would be carried out “on whatever scale is necessary” to restore
orderly markets. Moreover, the Treasury would fully – and quite
properly – indemnify the operation for any losses incurred.

But the BOE undermined this show of force by putting a time limit on its
emergency intervention. It stated that the planned sales from its Asset
Purchase Facility would be delayed from October 3 to October 31, and
that it would purchase up to £5 billion ($5.4 billion, as of September 28)
of gilts per day for 13 days. These dates were offered not as mere
estimates but as a firm interval.

On October 10, the BOE reported that it had bought only around £5 billion
of gilts in total over the course of eight daily auctions. It was a
demonstration of credibility at work. If market participants believe
that the MMLR is willing and able to intervene “on whatever scale is
necessary” to restore order, the actual intervention required may be small.
In the case of the European Central Bank’s Outright Monetary Transactions
(launched in 2012), no actual purchases were needed to restore market
functioning.

With £60 billion of unused capacity in its emergency facility, the BOE
then announced that it would increase the maximum size of the remaining
five auctions to £10 billion each. It also added index-linked gilts to
the program and initiated a temporary LOLR facility, the Temporary
Expanded Collateral Repo Facility, to extend further assistance to
stressed LDI funds; it eased collateral requirements for its regular
Indexed Long-Term Repo operations; and it made additional liquidity
available through a new, permanent Short-Term Repo facility, launched
the week of October 3.

All this made sense. But the BOE’s continued insistence that its emergency
gilt-purchase program would end on October 14 was unhelpful, because it
contradicted the assertion that it would carry out purchases on whatever
scale it deemed necessary. Moreover, that date was never credible. If
bondholders were to start dumping gilts again on October 15 or any later
date, the BOE would be right back to acting as a BOLR.

It is unclear whether the BOE’s emergency gilt purchases were on penalty
terms, which are necessary to minimize excessive risk-taking by market
participants who know that the central bank will intervene should fire
sales or other dysfunctional behavior threaten market functioning.
Penalty terms that apply when markets are disorderly are an important
complement to well-designed regulations constraining excessive risk-taking
when markets are orderly. But it can be difficult for a central bank to
determine a purchase price that is both materially more attractive to
would-be sellers than the disorderly market price as well as less
attractive than the (unobservable) orderly market price.

A separate but important issue is that the BOE’s Monetary Policy Committee
played no meaningful role in creating and implementing the emergency
program. That is surprising, considering that the new gilt purchases will
complicate and delay the process of bringing inflation back down to the
target rate. According to a statement by the BOE’s Deputy Governor for
Financial Stability, Jon Cunliffe, the MPC was merely “informed of the
issues in the gilt market and briefed in advance of the operation,
including its financial-stability rationale and the temporary and targeted
nature of the purchases.”

By emphasizing the temporary and targeted nature of the purchases, Cunliffe
seemed to be suggesting that they do not constitute monetary policy
operations. But, in that case, was the specific emergency program – both
the unsterilized asset purchases and the postponement of the asset
sales – formally recommended by the Financial Policy Committee, whose
mandate is financial stability? Cunliffe’s statement is ambiguous on this
question: “The FPC was engaged ahead of [the program’s] launch, recognizing
the risks to UK financial stability from dysfunction in the gilt market.
The FPC recommended that the Bank take action, and welcomed the Bank’s plans
for temporary and targeted purchases in the gilt market on financial
stability grounds at an urgent pace.”

Given that these emergency operations have both financial-stability
objectives and monetary-policy implications, they ought to have been
properly approved by all the designated decision-making bodies – the FPC
and the MPC. If that was not the case, the program’s legitimacy may be
significantly undermined.