Page last updated at 00:02 GMT, Wednesday, 11 March 2009

Bank takes first steps in new policy

By Kabir Chibber
Business reporter, BBC News

Gold bars
UK bonds are called gilts because they were once issued with gold edges

The Bank of England will take its first tentative steps under a new policy aimed at reviving the UK economy later.

The Bank will buy 2bn of government debt as it begins a policy of so-called quantitative easing.

It plans to inject a total of 75bn of new money into the ailing banking system as it seeks new ways to influence the economy after cutting interest rates to a low of 0.5%.

The extra money, made through buying government debt, is supposed to push down the longer-term cost of borrowing, make it easier for businesses and individuals to get credit and eventually boost consumer spending.

But there are also concerns that it will push down the value of annuities for people retiring, which are based on the yields of government bonds, as well as having unpredictable effects on the debt markets themselves.

Unanswered questions

The Bank's first move will be to buy bonds that mature between five and nine years, though that is just the beginning. "Asset purchase facility gilt purchase operations," as they're called, will now become part of the financial calendar for those left working in the City.

The Bank plans to conduct two weekly reverse auctions - when the sellers compete in order to drive down prices - on Mondays and Wednesdays. This will continue for the foreseeable future, with the total size of the Bank's purchase made known on the Friday.

The auctions will be announced the week before on the Thursday.

None of the fundamental models that we use will be able to operate in this environment
Peter Dixon, economist

If this all sounds very nice and normal, it is not.

The Bank is taking a step into the unknown by adopting this policy.

"They're pumping this money into the banking sector on the idea that it will be passed on to the wider economy, but I don't think anyone knows what's going to happen," said Peter Dixon, an economist at Commerzbank.

The idea that a major central bank would buy this much of its own government's debt would be unheard of only a few years ago. "The more we think about it, the more questions there are that we can't answer," Mr Dixon said.

Record low gilts

And the fluctuations have been felt in government bonds, a 703bn market that's not easily moved.

UK government debt is called gilts because the original certificates had a thin layer of gold, or were gilt-edged. They have become golden again since the Bank announced its new policy last week.

Woman standing before the Bank of England building
The Bank will now buy gilts in two auctions every week

The benchmark 10-year gilt had its biggest surge in prices in 17 years last week. The yield on the bonds dropped to 2.95%, the lowest since records started in the 1950s. (When bond prices rise, the yields they pay fall.)

The movements reflect the unprecedented nature of this particular form of intervention. It is hard to predict how markets will react as the Bank transforms itself into one of one of the biggest buyers of debt in the world.

"None of the fundamental models that we use will be able to operate in this environment," Mr Dixon said. "Supply and demand has moved out of all parameters."

Ironically, among those that will benefit from the move is the Bank itself. Mr Dixon notes the Bank will make a "chunky profit" on the gilts it holds.

That stood at 2.52bn as of February last year, the last available figures, according to a spokesman.

10-year gilt yields

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