The British pound sunk to a record low against the strong United States dollar this week, adding to market turmoil over fears of a broader recession.
There are a lot of questions about the pound’s plunge (and the dollar’s strength), particularly about why it is happening and what it will mean for the U.S., the United Kingdom, and the world. Here are answers to several common questions being asked in light of the retreat.
How much has it fallen?
The rout began after the newly sworn-in Conservative government in Britain, led by Prime Minister Liz Truss, announced its “mini-budget” plans on Friday. The Truss government wants to slash taxes while covering the cost of doing so by borrowing more, a scenario that raised the prospect of even higher inflation and government debt and thus led investors to shy away from the pound.
The pound fell by about 5% on Monday to a record low of $1.03 during trading in Australia and Asia before pulling back some of those losses when European markets opened later on Monday. On Tuesday, the pound was trading at $1.07. For reference, a year ago, the pound was above $1.35 against the greenback and was about $1.15 at the start of September.
The decline marks a precipitous 22% falloff in value from just six months ago. While the pound has been in gradual retreat against the dollar since May 2021, the quick drop following the new government’s announcement has caused anxiety for Britain and for investors.
What caused the recent plunge?
The U.K. has experienced a whole lot of changes in the past month or so. Queen Elizabeth II, who was Britain’s longest-reigning monarch, died at the age of 96, launching the country into a period of mourning that culminated in the accession of King Charles III.
Truss, the new prime minister, was sworn into office just two days before the queen died and after Prime Minister Boris Johnson, a fellow Conservative, announced his resignation over the summer in light of scandals and mass resignations from the government.
The U.K. is experiencing some of the worst inflation in the world, clocking in at about 10%, and energy prices have skyrocketed. There are also fears of a looming recession, given rising interest rates not only from the Bank of England, but also from major economies across the globe. Stabilizing the economic situation has been the Truss government’s No. 1 priority, but its Friday announcement of the tax cuts seemingly backfired.
When Chancellor of the Exchequer Kwasi Kwarteng announced the tax cuts, which are worth nearly $50 billion over five years, the idea was that it would spur economic growth and thus increase tax revenue, but many economists and investors panned the plan because it seemingly contradicts the goal of Britain’s central bank, which is to slow economic demand (and thus growth) in order to rein in inflation.
“In the U.K., a major experiment is starting as the state simultaneously puts its foot on the gas while the central bank steps on the brakes,” said German Finance Minister Christian Lindner about the move.
The downward drop of the pound itself is thought to be fueled in large part by concern and uncertainty from investors about the Truss tax cuts, which would slash income taxes and the tax on property sales.
“Exchange range movements are often a mystery because they’re affected by many economic factors, including just the mindsets of investors,” Gary Richardson, a professor of economics at the University of California at Irvine, told the Washington Post. “But it looks like the main trigger is the recent policy move by the British government.”
Even before the tax cuts announcement, though, the dollar had been gaining strength against all currencies as the Federal Reserve tightened monetary policy in the U.S. Since the start of March, right before the 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.
What does all this mean for the U.K.?
The lower pound is not good news for Britain’s inflation contagion. A huge proportion of international trade is priced in dollars, so it will take more sterling to pay for those goods, which is yet another blow to the country’s efforts to tamp down the soaring prices.
Goldman Sachs recently predicted that headline inflation in Britain 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. Britain imported nearly half of its food products in 2020, meaning that a big share of food items will bear the burden of a weaker pound.
The U.K. is a major trading partner with the U.S. It was the fifth-largest goods export market in 2019, according to the office of the U.S. Trade Representative. U.S. goods and services trade with the U.K. totaled an estimated $273.0 billion that year, with exports making up $147.4 billion of that.
Additionally, U.S. exports of goods and services to the U.K. supported an estimated 665,000 jobs in 2015, the last time information on the matter was available.
In reaction to the change in fiscal policy, many investors had hoped that the Bank of England would initiate an emergency interest rate hike to prop up the pound, although that did not come to fruition as the central bank just said it would monitor the situation.
What does it all mean for the U.S.?
The uncertainty surrounding the declining sterling further compounds investor fear in the U.S. Stocks have already taken a walloping on fears that the Federal Reserve could plunge the economy into a recession because of its aggressive rate hiking cycle, and the prospect of a currency crisis in Britain does nothing to soothe the markets.
After tumbling on Monday, stocks on Tuesday were broadly in the red, with the S&P 500 plunging to its lowest level since the start of the year as fear and uncertainty cloud the mind of investors.
The Chicago Board Options Exchange volatility index, known as the Fear Index, is intended to measure volatility in the markets. The VIX was up nearly 24% in just the past five days alone and, as of Tuesday, has increased by more than 100% since the start of the year.
The stronger dollar and weaker pound are also a bad combination for U.S. manufacturers who sell to buyers in Britain. Caterpillar, a major domestic producer of construction equipment, has seen its stock fall by nearly 27% in the past six months.
One positive aspect of the lower pound is that U.S. visitors to Britain will be able to cash in on some bargains should they decide to vacation abroad this year. Because of the exchange rate, goods and services purchased in the U.K. will be much cheaper for travelers than a year ago.
What lies ahead?
This is perhaps the greatest question of all and the one imbued with the greatest amount of uncertainty. Some firms have predicted that the worst of the pound’s plunge is ahead for investors.
Nomura, a major Japanese financial holding company, predicts that sterling will reach parity with the dollar sometime in November and expects the pound 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.
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Former Treasury Secretary Larry Summers lashed out against the Truss tax cuts in an interview with Bloomberg TV and predicted further collapse.
“It would not surprise me if the pound eventually gets below a dollar, if the current path is maintained,” the former U.S. official said. “This is simply not a moment for the kind of naive, wishful thinking, supply-side economics that is being pursued in Britain.”
