Sterling fell to its lowest level ever against the dollar on Monday, prompting analysts to compare its trajectory to that of an emerging market currency.
The drop followed sterling’s plunge in the wake of UK chancellor Kwasi Kwarteng’s £45bn tax-cutting package on Friday.
But the British pound has risen and fallen against the US dollar in the past, and since the second world war the direction has been consistently downward. In the postwar Bretton Woods system of fixed but adjustable exchange rates, sterling was initially set at $4.03 but the UK was unable to sustain the rate because of persistent trade deficits and currency outflows.
A large devaluation in 1949 was followed by another in 1967, and there were regular sterling crises with fixed exchange rates until the Bretton Woods system collapsed in 1971. In 1985, when the dollar was unsustainably strong, the pound reached its previous post-Bretton Woods low of just over $1.05.
Below, the FT looks at the significance of the current sterling crisis.
Why is sterling under pressure now?
Over the past 70 years, the persistent depreciation of sterling against the US dollar mostly reflects higher inflation in the UK than in the US, requiring a lower exchange rate to equalise price levels in both countries.
There is no doubt that recent falls in sterling represent the perception of a problem with the UK’s currency rather than simply US dollar strength. Sterling has gone down almost 3 per cent against the euro over the past week and more than 7 per cent against the currencies of the UK’s main trading partners since the start of August.
That perception in international financial markets reflects a view that the UK’s economic policy is moving in the wrong direction, just as it did after Brexit when sterling lost 10 per cent of its value.
The view holds that borrowing for permanent tax cuts is a reckless gamble by the government of Prime Minister Liz Truss that will increase the UK’s trade deficit, push up inflation and do little for growth.
Robert Wood, UK economist at Bank of America, said: “UK asset prices reacted to the fiscal package in a way more akin to an emerging market, with sterling and gilts selling off.”
The government has responded by saying it will not hold a spending review to raise public service expenditure this autumn in a bid to demonstrate fiscal responsibility. But markets are more focused on what ministers have announced rather than with their promises.
Should we worry?
Financial markets reflect the opinion of the vast majority of orthodox economists that initiating the largest tax cuts for 50 years is the wrong policy when unemployment is low and there is little spare capacity in the economy for additional non-inflationary growth.
The concern about Truss’s repeated pledge to ditch Treasury “orthodoxy” is that a rapidly falling pound will have unpleasant effects for most people in the UK and will curtail the government’s ambitions.
The falling value of sterling will increase inflation. The Bank of England has a rule of thumb that 60-90 per cent of the drop in the exchange rate would be felt in higher import prices. A 7 per cent depreciation in sterling’s value, therefore, should add 1.5 to 2 per cent to prices over two to three years. This will exacerbate the UK’s already high inflation and its cost of living crisis.
The higher rate of inflation and the need to attract foreign investment to finance the UK’s gaping trade deficit will also require higher interest rates. Financial markets now expect the BoE to raise rates to over 5 per cent next year, and the cost of government borrowing has shot up. Two-year borrowing costs have risen from 0.4 per cent a year ago to almost 4 per cent.
These higher borrowing costs will hit households and companies thinking about investment. Though exporters will gain from UK products being cheaper in international markets, the government’s borrowing for growth might even have the reverse effect.
Sushil Wadhwani, an asset manager and former BoE policymaker, said at the weekend: “It is very easy to see how the Truss-Kwarteng fiscal expansion leads to growth falling [with] a combination of interest rates having to go up a lot in response to a markets crisis and falling confidence.”
What can be done?
There are four possible avenues available to the UK authorities if they want to stem the decline in sterling.
First, the government could order the BoE to intervene in currency markets, buying sterling with foreign currency reserves. This is problematic, according to Sir John Gieve, former deputy governor of the Bank of England. “We don’t have very many reserves compared to the scale of currency market so I think that is not seen as an effective weapon,” he told the BBC on Monday.
The second is for the government to reverse its fiscal policy changes, but that would be extremely difficult for a new chancellor and prime minister.
Third, the BoE could raise interest rates to increase the return available to people holding money in the UK, much like many emerging economies have done this year. The central bank has indicated that further interest rate rises will be coming at its November meeting, but financial markets want action more quickly.
Fourth, senior officials at the BoE could seek to reassure markets by making clear that they will take immediate action if inflation or public borrowing get out of control. Talking up the pound, especially with the promise of higher interest rates to come, could be an effective weapon in restoring confidence.
What will the government do?
Kwarteng does not intend to reverse the debt-fuelled tax-cutting plan he set out last Friday. Indeed, he said on Sunday that there was “more to come” in terms of cutting the tax burden.
Chloe Smith, work and pensions secretary, on Monday reiterated that the chancellor would not change course. “The government is absolutely focused on delivering the growth package as we set out,” she said.
In an attempt to reassure markets that Kwarteng did not intend to ramp up spending ahead of a general election — further adding to debt — the Treasury said on Sunday that it would stick to current spending plans until 2025.
“It’s more important than ever that departments work efficiently to manage within existing budgets, focusing 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 course and that the BoE should put up rates to move away from “cheap money”.