Kwasi Kwarteng’s mini-budget has gone down badly in the financial markets. Mortgage rates have risen and the Bank of England has been forced to step in to halt a run on pension funds since the chancellor announced his policies on Friday.
The picture is complex and fast-moving, and the jargon used to explain it leaves much of the public feeling more confused. Here we examine 10 of those frequently bandied-around financial terms and concepts and explain what they actually mean.
1. Monetary policy
This is the job of the Bank of England, which since 1997 has had the statutory task of hitting the inflation target set by the government – currently 2%. The Bank’s nine-member monetary policy committee (MPC) has two main tools at its disposal to achieve this: interest rates and the buying or selling of government and corporate bonds.
2. Fiscal policy
The Treasury is responsible for fiscal policy, which involves taxation, public spending and the relationship between the two. Kwarteng’s mini-budget represented a fiscal easing, because the chancellor announced plans for tax cuts not matched by spending cuts. Markets expect the budget deficit – the gap between what the government spends and its tax revenues – to increase as a result. Government debt is the sum of annual budget deficits (and the less frequent surpluses) over time.
3. Government bonds
In the UK these are known as gilts, and are a way the state borrows to finance its spending. The fact that governments guarantee to pay investors back means they are traditionally seen as low risk. Bonds mature over different timescales, including one year, five years, 10 years and 30 years.
4. Bond yields and prices
View image in fullscreenWhen the Bank of England cuts interest rates, the fixed return on gilts becomes more attractive and prices rise. Photograph: Antonio Olmos/The Observer
Most bonds are issued at a fixed interest rate and the yield is the return on the capital invested. When the Bank of England cuts interest rates, the fixed return on gilts becomes more attractive and prices rise. However, when interest rates rise gilts become less attractive and prices fall. Therefore when bond prices fall, bond yields rise, and vice versa.
5. Short- and long-term interest rates
Short-term interest rates are set by the Bank of England’s MPC, which meets eight times a year. Long-term interest rates move up and down with fluctuations in gilt yields, with the most important the yield on 10-year gilts. Long-term interest rates affect the cost of fixed-rate mortgages, overdrafts and credit card borrowing.
6. Quantitative easing and quantitative tightening
When the Bank of England buys bonds it is called quantitative easing (QE), because the Bank pays for the bonds it is purchasing by creating electronic money, which it hopes will find its way into the financial system and the wider economy. Quantitative tightening (QT) – which has been planned by the Bank but has been delayed by the current crisis – has the opposite effect. It reduces the money supply through sales of assets.
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7. Pension funds and the bond markets
Pension funds tend to be big holders of bonds because they provide a relatively risk-free way of guaranteeing payouts to retirees over many decades. Movements in bond prices tend to be relatively gradual, but pension funds still take out insurance – hedging policies – as protection to limit their exposure. The rapid drop in gilt prices this week threatened to make these hedges ineffective.
8. Margin calls
Buying on margin is where an investor or institution buys an asset through a downpayment and borrows money to cover the rest of the cost. The upside of margin trading is that it allows big bets and higher returns when times are good. But investors have to provide collateral to cover losses when times are bad. In times of stress they are subject to margin calls, where they have to find additional collateral, often very quickly. Alarm bells started to ring in the Bank of England when it became clear that some pension funds were being faced with margin calls this week.
9. Doom loop
View image in fullscreenFinancial experts have warned that Britain’s economy could end up in a ‘doom loop’ of falling currency and rising interest rates. Photograph: MGP/Getty Images
This is where a financial crisis starts to feed on itself, because institutions are forced into a fire sale of their assets to meet margin calls. Pension funds were selling gilts into a falling market, and the result was lower gilt prices, higher gilt yields, bigger losses and further margin calls. It was at this point that the Bank of England stepped in to buy gilts, driving up the price and reducing yields.
10. Fiscal dominance
This is where the Bank of England is prevented from taking the action it thinks is necessary to combat inflation because of the size of the budget deficit being run by the Treasury. Fiscal dominance could take two forms: the Bank might keep interest rates lower than they would otherwise be, in order to reduce the government’s interest payments on its borrowing, or it might involve covering government borrowing by buying more gilts. The decision by the Bank to suspend gilt sales (QT) for a temporary period and replace it with gilt purchases (QE) is seen by some economists as an example of fiscal dominance.
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