How bad is the pound crisis?

Sterling fell to record low against dollar on Monday, prompting analysts compare its trajectories for emerging market currencies.

Sterling tumbled on Friday after Chancellor Kwasi Kwarteng proposed a £45bn tax cut.

But the pound has risen and fallen against the dollar in the past, and has been trending downward since World War II. In the fixed but adjustable exchange rate system of the post-war Bretton Woods system, the pound was initially set at $4.03, but the UK was unable to maintain that rate due to persistent trade deficits and currency outflows.

A sharp devaluation in 1949, another sharp devaluation in 1967, before the collapse of the Bretton Woods system in 1971, was often followed by a fixed exchange rate sterling crisis. In 1985, when the dollar strengthened unsustainably, the pound reached its post-Bretton Woods level below $1.05.

Below, the Financial Times looks at the significance of the current sterling crisis.

Why is the pound under pressure now?

The continued depreciation of the pound against the dollar over the past 70 years mainly reflects higher inflation in the UK than in the US, which requires a lower exchange rate to balance the price levels of the two countries.

There is no doubt that the recent fall in the pound represents a view of the UK currency issue, not just a stronger dollar. Sterling has fallen nearly 3% against the euro over the past week and has fallen more than 7% against the currencies of Britain’s main trading partners since early August.

This perception in international financial markets reflects the view that UK economic policy is heading in the wrong direction, as did the 10% drop in the value of the pound after Brexit.

The argument is that borrowing for permanent tax cuts is a reckless gamble by Prime Minister Liz Truss’ government, which will increase Britain’s trade deficit, push up inflation and do little for economic growth.

Robert Wood, UK economist at Bank of America, said: “UK asset prices are reacting more to the emerging markets’ response to the fiscal package, with sterling and gilts selling off.”

The government responded by saying there would be no spending review to boost public service spending this autumn to demonstrate fiscal responsibility. But markets focus more on what ministers announce than what they promise.

Should we be worried?

Financial markets reflect the view of the vast majority of orthodox economists that launching the largest tax cut in 50 years is the wrong policy when unemployment is low and there is no spare capacity for additional non-inflationary growth in the economy.

Concerns over Truss’s repeated pledges to abandon Treasury “orthodoxy” are that a rapid fall in the value of the pound will have an unpleasant effect on most people in the UK and will undercut the government’s ambitions.

A weaker pound will increase inflation. The Bank of England has a rule of thumb that 60% to 90% of a fall in the exchange rate occurs when import prices rise. So a 7% drop in the value of the pound should increase prices by 1.5% to 2% over two to three years. This will exacerbate Britain’s already high inflation and its cost of living crisis.

Higher inflation and the need to attract foreign investment to finance Britain’s widening trade deficit also require higher interest rates. Financial markets now expect the Bank of England to raise interest rates to more than 5% next year, while government borrowing costs have soared. Two-year borrowing costs have risen to nearly 4% from 0.4% a year ago.

UK government bond yield line chart (%) shows government borrowing costs are rising, but have soared since Friday's statement

These higher borrowing costs will hit households and companies considering investing. While exporters would benefit from lower prices for British products on international markets, government borrowing for growth could even have the opposite effect.

Sushil Wadhwani, an asset manager and former BoE policymaker, said over the weekend: “It’s easy to see how the Truss-Kwarteng fiscal expansion could lead to a drop in growth. [with] Interest rates had to rise sharply in response to a market crisis and a drop in confidence. “

What can be done?

If the British authorities want to stop the pound from falling, there are four possible avenues at their disposal.

First, the government could order the Bank of England to intervene in the currency market, using reserves to buy sterling. That’s problematic, according to former Bank of England deputy governor Sir John Giff. “We don’t have a lot of reserves compared to the size of the currency market, so I don’t think it’s an effective weapon,” he told the BBC on Monday.

The second is the government’s change in reversing its fiscal policy, but this will be extremely difficult for the new prime minister and prime minister.

Third, the Bank of England may raise interest rates to increase the returns available to those who hold currency in the UK, as many emerging economies have done this year. The central bank has said it will raise interest rates further at its November meeting, but financial markets want quicker action.

Fourth, senior BoE officials can reassure markets by making it clear that they will act immediately if inflation or public borrowing gets out of hand. Inflating the pound, especially with the promise of imminent higher interest rates, could be an effective weapon in restoring confidence.

What will the government do?

Kwarteng has no plans to reverse the debt-fueled tax cuts he proposed last Friday. In fact, he said on Sunday that “more needs to be done” to reduce the tax burden.

Work and Pensions Minister Chloe Smith reiterated on Monday that the chancellor would not change course. “The government is absolutely focused on delivering the growth plans we have laid out,” she said.

In a bid to reassure the market that Kwarteng does not intend to increase spending ahead of the general election — adding further debt — the finance ministry said on Sunday it would stick to its current spending plan until 2025.

“It is more important than ever that departments are managed effectively within existing budgets, focused on unlocking growth and delivering high-quality public services,” it said.

Gerard Lyons, who has been advising the new Truss government on economic policy, said on Monday that Kwarteng should stick to his line and the Bank of England should raise interest rates to get rid of “cheap money”.

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