The central bank said today it will purchase 2 billion pounds ($2.7 billion) of gilts, its first deployment in a three- month plan that may see it spend 75 billion pounds. The results of the operation will be released after 2:45 p.m. in London.

The move marks a new departure for British monetary policy after officials cut the interest rate to a record low of 0.5 percent on March 5, requiring them to seek new tools to stop the economy’s downward spiral. While Governor Mervyn King hopes that pumping new money into the financial system will work, he’s relying on banks battered by the crisis to pass it onto lenders.

“For the economy, this is money that can now be spent elsewhere,” said George Buckley, chief U.K. economist at Deutsche Bank AG in London. “The risk is that it’s not used to lend but is kept in reserves. We don’t know what this is going to do because we don’t know where the money goes.”

The bank unveiled the plan after last week’s rate cut. Policy makers such as Andrew Sentance are concerned a “prolonged and deep recession” will stoke deflation and the National Institute of Economic and Social Research said today that the slump deepened in the quarter through February.

Shopping List

King, criticized at the start of the crisis for not doing enough, argues that the new measures “will work in the long run.” The central bank will buy six different kinds of government bonds in today’s operation, whose maturities range from 2014 to 2018. They include the 5 percent bond maturing in September 2014, the 4.75 percent bond maturing September 2015 and the 8 percent bond maturing December 2015.

The operation takes place in two stages. Until 12 p.m. in London, investors can offer gilts for sale to the bank without specifying a price. At 1 p.m., the bank announces the result of its purchases and says how much it then plans to buy from bondholders who wish to name their price in competitive bidding. That stage takes place from 2:15 p.m. until 2:45 p.m.

“The first few weeks will tell us a lot about how it’s going to go,” said John Wraith, head of sterling interest-rate strategy at RBC Capital Markets in London. “The market is now at a level where yields are much lower now than fundamentals would justify, so they have to back this up by actually buying the bonds at these levels.”

The yield on 10-year gilts was little changed at 3.11 percent as of 10:35 a.m. in London. Two-year gilt yields rose five basis points to 1.37 percent. Bonds prices move inversely to yields.

Bond Yields

As well as increasing the money available to banks to lend to companies and homebuyers, the Bank of England wants to push down yields on gilts, so that investors start to diversify into higher-yielding products, such as corporate debt, said Wraith.

The yield on 10-year gilts posted its biggest two-day drop since at least 1989 in the final two days of last week, shedding 58 basis points, after policy makers announced the asset-buying program on March 5. The rally continued March 9, when the yield dropped to the lowest level in at least 20 years. The yield slipped 3 basis points to 3.073 percent today.

King said last week he’s confident that the bond purchases will help return inflation to the 2 percent target. The central bank’s forecasts, published last month, show the inflation rate dropping to 0.3 percent in early 2011.

The U.K. economy shrank 1.8 percent in the quarter through February, the National Institute of Economic and Social Research estimated today. That’s faster then the 1.5 percent contraction in the final three months of 2008, the biggest since 1980.

‘Vigilant, Watchful’

Nigel Lawson, the longest-serving finance minister under Margaret Thatcher, said yesterday that the Bank of England must be “very vigilant, very watchful” to prevent a resurgence of inflation should the new money kick-start the economy.

“The difficulty they have is that there’s a lag in time in doing it and it starting to feed through,” said Ian Williams, chief executive officer of Charteris Portfolio Managers in London. “You may end up with the proverbial brick on the end of a bit of elastic, where they’re tugging and tugging nothing appears to be happening, and all of a sudden the brick hits them in the face.”

 SOURCE: Bloomberg