The British pound plunged to a record low against the dollar on Monday as the United Kingdom announced plans for new tax cuts and borrowing, adding to existing upward pressure on the dollar from the Federal Reserve’s campaign to raise interest rates to counter inflation.
Sterling fell by about 5% to a record low of $1.033 during trading in Australia and Asia before paring back some of those losses when European markets opened on Monday and began trading at about $1.08, still a historically low level. For reference, a year ago, the pound was above $1.30 against the greenback.
The downward lurch came after newly sworn-in Chancellor of the Exchequer Kwasi Kwarteng announced that the country would implement the largest tax cuts in five decades — worth nearly $50 billion — while increasing government spending and borrowing.
The government, led by Conservative Prime Minister Liz Truss, is pursuing the cuts for the purpose of creating economic growth, although the sheer magnitude of the tax cuts surprised many economists.
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“What I’m determined to do as prime minister and what the chancellor is determined to do is make sure we are incentivizing businesses to invest, and we’re also helping ordinary people with their taxes,” Truss said Sunday on CNN’s State of the Union.
The big tax cuts have prompted speculation that the Bank of England will have to tighten monetary policy even more. The yield on two-year British bonds popped to 4.52%, the highest level since 2008. Markets are now pricing in more than 150 basis points in rate hikes by when the British central bank is set to meet in November. Some are calling for an emergency rate hike this week.
“Serious questions are already being asked about the economic competency of the new government,” said Craig Erlam, senior market analyst at OANDA, according to CNN. “So much so that markets are factoring in a strong chance of a substantial emergency rate hike from the Bank of England in order to shore up the currency and confidence in the markets.”
While dealing with a possible currency crisis, Britain is also grappling with skyrocketing inflation. Goldman Sachs recently predicted that inflation in the United Kingdom could top out at over 22% and that the country’s gross domestic product could fall by 3.4%, should energy costs continue to rise.
Apart from the new U.K. policies, though, the dollar has also risen relative to the pound, euro, and other currencies in recent months.
Over the summer, the exchange rate between the euro and the dollar reached parity, meaning the two currencies are worth about the same amount, a phenomenon that hadn’t occurred in two decades. That comes as the Fed is carrying out its most forceful rate-hiking cycle since the Great Inflation some 40 years ago.
As of Monday, 1 euro was worth $0.97, a nearly 15% decline from the start of the year alone and a precipitous 17% decrease from this time last year, when 1 euro was worth $1.17.
Since the start of March, right before the U.S. Fed started increasing its interest rate targets, the dollar, as measured by the dollar index, has risen by more than 15%. The value has increased by some 18.6% since the start of the year.
The strong dollar and weaker euro and pound have major implications for world trade. The rising greenback socks U.S. manufacturers that produce goods domestically and also do business abroad — for instance, Caterpillar and John Deere.
“The strong dollar is really bad news for our companies that need to sell abroad if they’re manufacturing in the U.S. or having to price their output in dollars,” Connel Fullenkamp, professor of the practice of economics at Duke University, told the Washington Examiner earlier this month.
Some economic analysts aren’t anticipating that the pound will climb higher anytime soon. Nomura, a major Japanese financial holding company, predicted on Monday that the pound will reach parity with the dollar sometime in November and expects sterling to fall to $0.975 by the end of the year and $0.95 in the first quarter of next year.
“This is a fundamental balance of payments crisis, with politicians hoping it will eventually just calm down. Hope is not a strategy, and markets are reflecting that,” Nomura analysts said in a research note.
Former U.S. Treasury Secretary Larry Summers, a Democrat who was one of the first to warn about the threat of inflation back in 2021, lambasted the new British government’s economic policy and said he thinks sterling could tumble below the value of the dollar.
“It would not surprise me if the pound eventually gets below a dollar if the current policy path is maintained,” he told Bloomberg.
The falling pound comes as the threat of global recession looms larger by the day. U.S. financial markets have been in panic mode for the past two weeks as investors appear to be resigning to the idea that the Fed won’t be able to slow inflation without inducing a recession.
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August’s worse-than-expected consumer price index report found inflation ticked down to 8.3% for the 12 months ending in August, but that number that was higher than economists had expected. That, coupled with the central bank jacking up rates by 75 basis points for a third consecutive time, has caused fear that the economy and the strong labor market will start getting socked.
The fear and uncertainty are captured by the “VIX,” also known as the “fear index.” The Chicago Board Options Exchange volatility index is intended to measure volatility in the markets. The index was up nearly 20% this month and up some 84% since the start of the year.
