Department of Economics Brown Bag Seminar with Nicolo Bandera The monetary consequences of financial stability interventions - assessing the UK LDI crisis and the central bank policy response

We analyse the UK gilt market dysfunction which occurred in September 2022 using a quantitative DSGE model. We introduce a financial sector with several actors, including pension funds and liability driven investment (LDI). LDI pools offer pension funds leveraged exposure to index-linked gilts, which we model explicitly alongside conventional long-term gilts and money. Following a risk-premium shock, LDI activity amplifies the fall in gilt prices, replicating the market dynamics observed in 2022. In policy space, we find that the purchases conducted by the Bank of England were successful in offsetting LDI-driven gilt market dysfunction. The temporary, targeted nature of these purchases was crucial in avoiding monetary spillovers. We estimate that a trivial increase in interest rates worth 1—5bps was sufficient to offset any inflation impact, but a more persistent intervention would require 20—40bps. This result holds even if the public mistakenly believes the intervention will be persistent. We also model an NBFI repo tool; if well-designed, this would be equally effective with a reduced impact on the central bank balance sheet. Finally, we consider a macroprudential liquidity buffer and show that the “market stress” buffer introduced in 2023 would have offset approximately half the LDI effect.