Kwasi Kwarteng’s mini-budget has gone bad in financial markets. Mortgage rates have risen and the Bank of England has been forced to intervene to end a run on pension funds since the Chancellor announced his policy on Friday.
The image is complex and fast-paced, and the jargon used to explain it leaves much of the audience more confused. Here we take a look at 10 of these frequently used financial terms and concepts and explain what they actually mean.
1. Monetary policy
This is the role of the Bank of England which, since 1997, has had the statutory mission of achieving the inflation target set by the government, currently 2%. The Bank’s nine-member Monetary Policy Committee (MPC) has two main tools to do 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, government spending, and the relationship between the two. Kwarteng’s mini-budget represented fiscal easing, as the chancellor announced plans to cut taxes unaccompanied by spending cuts. Markets expect the budget deficit – the gap between government spending and its tax revenue – to rise accordingly. Public debt is the sum of annual budget deficits (and less frequent surpluses) over time.
3. Government bonds
In the UK, they are known as gilts and are a way for the state to borrow to finance its expenditure. The fact that governments guarantee to reimburse investors means that they are traditionally considered low risk. Bonds mature on different time scales, including one year, five years, 10 years and 30 years.
4. Bond yields and prices
Most bonds are issued at a fixed interest rate and the yield is the return on the capital invested. When the Bank of England lowers interest rates, the fixed yield of gilts becomes more attractive and prices rise. However, when interest rates rise, government securities become less attractive and prices fall. So 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 MPC of the Bank of England, which meets eight times a year. Long-term interest rates rise and fall with fluctuations in gilt yields, the most important being the yield on 10-year gilts. Long-term interest rates affect the cost of fixed rate mortgages, overdrafts and credit card borrowings.
6. Quantitative easing and quantitative tightening
When the Bank of England buys bonds, it’s called quantitative easing (QE), because the Bank pays for the bonds it buys by creating electronic money, which it hopes will find its way into the financial system and the wider economy. Quantitative tightening (QT) – planned by the Bank but delayed by the current crisis – has the opposite effect. It reduces the money supply by selling assets.
7. Pension funds and bond markets
Pension funds tend to be big bondholders because they provide a relatively risk-free way to guarantee payouts to retirees for many decades. Bond price movements tend to be relatively gradual, but pension funds continue to buy insurance – hedging policies – as protection to limit their exposure. The rapid drop in gilt prices this week threatened to render these hedges ineffective.
8. Margin calls
Buying on margin is when an investor or institution buys an asset through a down payment and borrows money to cover the rest of the cost. The advantage of margin trading is that it allows for big bets and higher returns when times are good. But investors must provide collateral to cover losses when times get tough. In times of stress, they are subject to margin calls, where they must find additional collateral, often very quickly. Alarm bells started ringing at the Bank of England when it became clear that some pension funds were facing margin calls this week.
9. Doom Loop
This is where a financial crisis begins to feed on itself, as institutions are forced to sell off their assets to meet margin calls. Pension funds were selling gilts in a falling market, leading to lower gilt prices, higher gilt yields, bigger losses and new margin calls. This is when the Bank of England stepped in to buy gilts, driving up prices and reducing yields.
10. Tax domination
This is where the Bank of England is prevented from taking the measures it deems necessary to fight inflation due to the size of the budget deficit managed by the Treasury. Fiscal dominance could take two forms: the Bank could keep interest rates lower than they would otherwise be, in order to reduce government interest payments on its borrowing, or it could involve hedging public borrowing by buying more gilts. The Bank’s decision to temporarily suspend gilt sales (QT) and replace them with gilt purchases (QE) is seen by some economists as an example of fiscal dominance.
