The Reasons Underlying the Pound’s Crash in September
Note: this article was written on Wednesday 28th September
“Shaken and stirred.” The past week has been tumultuous for the UK economy, and specifically the Pound Sterling. Rocked by new Chancellor Kwasi Kwarteng’s dramatic expensive mini-budget, the pound sterling has plummeted to record lows, almost at (unheard of) parity with the dollar. In a quintessential mark of British anxiety, investors were unconvinced with the tax-cutting growth measures outlined on Friday and specifically how they would be funded, sending the pound on a downward trend - during the speech itself! It has also had secondary effects on the rapid withdrawal of hundreds of mortgage products and a direct threat to pensions. Here’s a quick look at the economics behind it.
Let’s split it into 2 types of factors: pre-budget and post-budget.
Pre-budget
The strong dollar - throughout the inflation crisis this year, the Fed has stuck to its guns, being ‘hawkish’ in its aggressive interest rate raises, trying to stem inflation. This relates to the concept of ‘hot money’, money that flows between economies looking for the best returns i.e. the best interest rates. This has meant an increased demand for the dollar, which is at a 20-year high. Unfortunately, if the see-saw goes up one way, it’s got to go down on the other. Lots of dollar purchases mean a greater supply of other currencies, reducing their value and price. Because the US Dollar is the international reserve currency, normally stable and safe, the currency used to purchase barrels of oil, currently at high prices as well, and also US bonds with promising returns currently on the back of interest rate hikes, the Dollar is particularly strong, damaging other currencies.
Excessive UK borrowing - the UK’s net government debt is a hefty £2.2 trillion, a shade under 100% of the GDP. The announcement of the energy price guarantee means at least another £100bn added onto this. Notably however, Prime Minister Truss refused to put an exact figure, “extraordinary challenges call for extraordinary measures”, making investors uneasy. Combined with inflation, this increases the supply of the pound which obviously makes it worth less.
The prospect of a recession - the bleak economic outlook, driven by high inflationary pressure and low growth, reduces the belief in the UK economy and thus its’ representative on the markets, the pound. It is worth noting that a weak pound heightens import prices, further adding to the fire of inflation in a potentially vicious cycle.
Lack of confidence in the Bank of England - attacked during Liz Truss’ campaign for PM, the BoE and its governor Andrew Bailey has been on the headlines for the wrong reasons. Being thrust the blame for ineffective monetary policy, the Bank hasn’t been able to be as cut-throat as Jay Powell’s Federal Reserve have been across the Atlantic, when in fact the majority of this inflation is cost-push, to which the governor is “helpless”. This was perfectly illustrated last week when the Fed increased its base rate by a confident 0.75 percentage point, followed by Threadneedle Street’s more meek raise of 0.5% to 2.25%. Therefore, despite the theoretical expectation of the pound rallying after a rise in interest rates, the missing conviction and strong assurance from the BoE has impacted the position of the pound.
Embroiled in these troubling causes, the past week of announcements from Westminster have rubbed salt into the wounds.
Post budget
Lack of borrowing plans - in an unusual, perhaps arrogant, fashion, Liz Truss and Kwarteng refused to permit the Office for Budget Responsibility to release its independent forecasts regarding the economic impact of the many tax cuts and expansionary fiscal measures ahead of the budget - an irresponsible decision you may argue (since then, the Institute for Fiscal Studies proposed £190bn this year, then £100bn/year for the next four). On top of this, the classical free-market Chancellor ripped the rule book of fiscal discipline, announcing massive unfunded government borrowing and delaying when he would confirm where the money will come from until November 23. This was the knockout punch for investors, confused as to where the money would come from. Unimpressed by the lack of sound economics and real effectiveness in Kwarteng’s plan, the pound tumbled to $1.03 on Monday morning, after Kwarteng suggested there would be more tax cuts. The prices and yields of government bonds (gilts) also rose dramatically, close to 20-year highs. This wasn’t helped by an IMF statement on Tuesday, expressing disapproval towards the UK’s fiscal plans and warning against further turmoil and potential inequality, continuing to dampen the UK economic picture.
The Bank’s actions - left in a dreadful stance, the Bank initially try to reassure markets on Monday, announcing that it wouldn’t hesitate to continue increasing interest rates. However, that didn’t meet investor hopes of a potential emergency meeting of the MPC (those who set the base interest rate). Therefore, on Wednesday afternoon, the Bank set out a short-term plan of buying a total of £65bn of government bonds to soothe panic in the financial markets and avert a “material risk to UK financial (services industry) stability”. However, the subsequent slight drop in the pound highlights that even if the Bank puts out all the stops it can, which it is beginning to signal that it will, an economic crisis may be unavoidable. Ultimately, this significant step shows a lack of cohesion between the Treasury and the Bank with the Bank having to step up in an emergency fashion.
Brexit, the COVID-19 pandemic and then the Russo-Ukrainian War: some might call this a perfect storm. Unfortunately, the UK economy has been further struck by a whirlwind of factors, some controllable, some not. And it’s all being thrust upon the Pound Sterling. Buckle in for the ride, the next few weeks are set to be eventful.
Aditya Muthukumar
(Sources include BBC News, The Guardian and Financial Times)