How will Treasury and Bank of England react to the pound's plunge?

The pound has slumped against the US dollar. Credit: PA

How will and how should the Bank of England, and the Treasury, react to this morning's continued fall in the value of the pound?

I've been talking to former Bank of England executives and ex-Treasury officials, who make clear that the stakes are incredibly high and that reassuring markets will not be easy. 

This further devaluation in the currency is a serious problem for the Chancellor, Kwasi Kwarteng, after his maxi "mini-budget" on Friday, because it means the price of imports will continue to rise, stoking already-high inflation.

And it raises the spectre that the government will struggle to borrow what it needs at acceptable interest rates, because of the falling value (in dollar terms) of sterling-denominated assets.

The fall in the value of sterling carries a simple message: investors are concerned that the Bank of England will not raise interest rates as much as they deem necessary, after what they see as the inflationary impact of Kwarteng's budget. 

This in turn puts the onus on the Bank of England to prove markets wrong.

There are two ways the Bank can do that.

First, it could hold an emergency meeting to raise interest rates by more than the 0.5% announced only last Thursday.

That, however, would almost certainly be a disaster for the reputations of the Bank of England and of the Treasury - and would only be a very last resort, in extreme crisis.

How so?

If the Bank of England held such an emergency meeting on its own initiative, it would in effect be telling the world it had lost confidence in Kwarteng and the Treasury - because it would be saying that such is the damage wreaked by Kwarteng to the value of UK assets, the Bank could not risk waiting till its 3 November meeting to assess the inflationary impact of the budget.

That would be a reputational blow to Kwarteng - and his prime minister, Truss - from which they would struggle to recover.

If however, the Bank of England met in an emergency session at the urging of the Treasury, at that juncture the precious independence of the Bank of England would be undermined. 

It would be seen as Kwarteng ordering around the governor of the Bank of England, Andrew Bailey, and (paradoxically) it could further undermine the value of the pound - because investors would conclude that interest-rate decisions were being tainted by political considerations.

And to be clear, any kind of joint Treasury/Bank decision for an emergency meeting of the MPC would equally undermine the important perception of Bank of England independence. 

So as I say, if the Bank of England's monetary policy committee were to meet this week to push up interest rates, ahead of November's scheduled meeting, it would be a big and terrible moment for the government - not unlike the body blow to the then Tory government's reputation almost exactly 30 years ago, when sterling crashed out of the European Exchange Rate Mechanism and was a monetary crisis that led directly to Labour's landslide in 1997.

So what will and should the Bank of England do?

Well, it is a reasonable assumption that the governor of the Bank of England and other members of the Monetary Policy Committee will at this very moment be looking at their engagements to give speeches in the coming week.

And they will be hastily redrafting those speeches to contain phrases that make it crystal clear to markets (and us) that interest rates will have to rise very significantly at the next scheduled MPC meeting, as a direct consequence of Kwarteng's fiscal loosening.

They will be saying "trust us to do the right thing at the next available opportunity, on 3 November".

And if Governor Bailey feels he has the luxury, he won't make that statement about interest rates having to increase today, but will wait till Wednesday.

Because doing it today again would look like a panicked reaction - perhaps urged by the Kwarteng - and could end up doing as much harm as good. 

To be clear, there are risks associated with the Bank saying little or nothing about how it intends to put up interest till tomorrow or - more probably - Wednesday.

But the big risk of taking evasive action, with an emergency meeting, is that confidence in the competence of both the Treasury and Bank of England would be undermined. 

That would obviously hurt Kwarteng, Truss, and the standing of the Tory Party.

But it would also hurt all of us, because it would bring the probable consequence that interest rates would have to increase by more and for longer, to restore precious credibility. 

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