A crash in the pound will make inflation worse and interest rates will rise

CNN business

The UK government’s decision to introduce its biggest tax cuts in 50 years to subsidize rising energy costs this winter by borrowing tens of billions of dollars is a massive gamble that has sent ripples through financial markets.

Since Finance Minister Kwasi Kwarteng formally announced the plans on Friday, the British pound has fallen 5% against the US dollar, taking losses so far this year to 21%. The euro, for comparison, has fallen by around 15% against the dollar in the same period.

The agitation does not end there. Investors have raced to dump UK government bonds as they worry about an additional 72 billion pounds ($77 billion) of debt due before April. The yield on 5-year debt, which moves against prices, has jumped from about 3.6% to more than 4.4% in the last two trading sessions – an astronomical jump in a corner of the financial universe that usually registers movements in small chunks. the percentage

The Bank of England said in an emergency statement that it was “monitoring developments in financial markets very closely”, while the UK Treasury said plans to ensure the sustainability of government finances would be released later this year.

But that may not end the chaos, and its effects will not be limited to the markets. The drop in the pound is bad news for an economy that may already be in recession as it becomes more expensive to import essential goods such as food and fuel. This could reignite decades of inflation fueling a cost-of-living crisis for millions of households.

As a result, the Bank of England will come under pressure to raise interest rates further and faster. This would raise the cost of borrowing for businesses and individuals, leaving less money for businesses to invest and consumers to spend.

“This is a painful reminder that economic policy is not a game,” said Torsten Bell, CEO of the Resolution Foundation, a think tank focused on improving the living standards of low- and middle-income households. He has sharply criticized the UK government’s proposals.

The pound hit a record high against the dollar on Monday, falling to around $1.03 before recovering to nearly $1.07.

When a currency loses value, it can help manufacturers by making their exports cheaper. But given the broader economic climate, few would see the sharp decline as a positive development.

A big concern is what paying for imports will mean. The cost of energy is a particular concern as the weather turns cold.

As goods are usually paid for in dollars, a rising greenback and falling sterling will mean higher prices for UK importers. And while European countries are racing to stockpile natural gas to reduce their dependence on Russia, the UK lacks similar storage capacity and will suffer even more from market prices.

Then there is the rapid rise in borrowing costs for government, businesses and households. Investors expect the Bank of England to raise interest rates much more aggressively to control inflation. They now plan to raise rates to around 6% by next spring.

Rates have not been this high since 2000. The central bank only started in December, when rates were at 0.1%, so the quick pivot could cause a big economic shock.

“Rising interest rate expectations have already added another £1,000 a year to the rise in mortgages for a typical borrower, and falling sterling means more expensive imports are fueling higher inflation,” Bell said. People living in the UK would see their standard of living drop as a result, he added.

Halifax, owned by Lloyds Bank (LLDTF), withdrew some of its mortgage products, and Virgin Money stopped taking mortgage applications from new customers until “later this week” due to wild market moves.

Turmoil in financial markets prompted the Bank of England to say on Monday it would review the government’s plans for inflation at its next meeting in November and “will not hesitate to adjust interest rates as necessary”.

The bank published its comments after the UK Treasury said Kwarteng would outline plans to ensure UK debt sustainability on November 23, at which point the country’s budget watchdog would be asked to publish an updated forecast.

It is unclear, however, whether these comments will be enough to quell alarm among investors, who are worried about the government’s unorthodox approach.

“It remains to be seen whether today’s statement from the government and the Bank of England will be enough to ease the markets’ fears about the government’s fiscal policy,” said Paul Dales, chief UK economist at Capital Economics.

Over the weekend, Kwarteng doubled down, suggesting more tax cuts were to come and insisting Friday’s measures were “just the beginning” as the government attempts to boost growth.

Mujtaba Rahman, managing director for Europe at consultancy Eurasia Group, believes Kwarteng and Prime Minister Liz Truss are unlikely to return despite the strong investor backlash.

“For now, they will try to ride out the storm,” Rahman said.

That leaves markets looking to the Bank of England to stop the bleeding.

“I think monetary policy will be decisive in the near term,” said James Ashley, head of international market strategy at Goldman Sachs Asset Management.

The central bank has not indicated that it will raise interest rates outside of its regular meeting schedule. James Rossiter, head of global macro strategy at TD Securities, said the Bank of England is likely discussing the possibility, but may be concerned it could further damage the UK’s credibility with foreign investors.

It is more common for central banks in emerging markets to intervene to defend their home currencies, he noted, although Japan intervened last week to prop up the yen for the first time in 24 years.

The Bank of England will almost certainly have to be more confident going forward, especially as the half-point interest rate hike unveiled last week looks too small. Economist Mohamed El-Erian, an adviser to Allianz, told the BBC that the central bank should raise interest rates by “a full percentage point” to try to stabilize the situation.

In the meantime, a fundamental issue could continue to fuel volatility. While the Truss government aims to boost demand to fight a recession this winter, the Bank of England is trying to cool the economy in order to put a lid on the fastest price rises among the G7 countries. This tension will reduce confidence in the way forward.

“If the markets still don’t believe in the fiscal picture, I’m not sure how the Bank of England wins this,” Rossiter said.

– Rob North contributed to this article.