The UK government’s decision to implement the biggest tax cuts in 50 years while borrowing tens of billions of dollars to subsidize rising energy costs this winter is a huge gamble that has sent shockwaves through financial markets.
Since Friday, when Finance Minister Kwasi Kwarteng formally announced the plansthe pound sterling has plunged 5% against the US dollar, taking its total losses so far this year to a whopping 21 percent. The euro, by comparison, is down 15 percent against the dollar over the same period.
The turmoil does not end there. Investors have been quick to dump UK government bonds as they are concerned about an extra £72bn in loans due before April. The yield on 5-year debt, which moves opposite prices, jumped from around 3.6% to more than 4.4% in the last two trading sessions, an astronomical jump in a corner of the financial universe that normally sees movements in small fractions of a percent.
the bank of england said in an emergency statement that it was “very closely monitoring developments in the financial markets”, while the UK Treasury said plans to ensure the sustainability of government finances would be published later this year.
But that may not end the chaos, the consequences of which will not be limited to markets. A falling pound is bad news for an economy that may already be in recession, as it makes it more expensive to import essential goods like food and fuel. That could stoke decades-high inflation that is fueling a cost-of-living crisis for millions of households.
Consequently, the Bank of England will come under pressure to raise interest rates faster 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, executive director of the Resolution Foundation, a think tank that focuses on improving living standards for low- to middle-income households. He has been highly critical of the UK government’s proposals.
WHY A SINKING POUND IS BAD NEWS
The pound hit a record low against the dollar on Monday, falling around $1.03 before recovering to almost $1.07.
When a currency loses value, it can be useful to manufacturers, making their exports cheaper. But given the broader economic climate, few would frame the sharp drop as a positive development.
A big concern is what it will mean to pay for imports. The cost of energy is a particular concern as the weather gets colder.
Since commodities are generally paid for in dollars, a rising dollar and falling pound sterling will mean higher prices for UK importers. And while countries in Europe have rushed to stockpile natural gas as they try to reduce their reliance on Russia, the UK lacks similar storage capacity, leaving it even more exposed to prevailing market prices.
Then there is the rapidly rising borrowing costs for the government, businesses, and households. Investors expect the Bank of England will need to raise interest rates much more aggressively to control inflation. They are now targeting a rate hike of around 6% by next spring.
Rates haven’t been this high since 2000. Since the central bank only started to hike in December, when rates stood at 0.1 percent, the quick turn around could trigger a substantial economic whiplash.
“The rise in interest rate expectations has already added another £1,000 a year to the next mortgage hike for a typical borrower, while the drop in sterling means more expensive imports translate into higher inflation.” Bell said. As a result, people living in the UK will see a drop in living standards, she added.
Lloyds Bank-owned Halifax has scrapped some of its mortgage products, while Virgin Money stopped accepting mortgage applications from new customers until “later this week” due to wild market moves.
ASKING FOR CALM
The turmoil in financial markets prompted the Bank of England to say on Monday it would review the effects of the government’s plans on inflation at its next meeting scheduled for November and “would not hesitate to change interest rates as necessary.”
The bank issued its comments shortly after the UK Treasury said Kwarteng would outline plans to ensure UK debt sustainability over the medium term on Nov. 23, and the country’s budget supervisor would be asked to publish an updated forecast at that time.
However, it is unclear whether these comments will be enough to reduce alarm among investors, who are concerned 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 allay markets’ fears about the government’s fiscal policy,” said Paul Dales, chief UK economist at Capital Economics.
Over the weekend, Kwarteng doubled down, hinting at more tax cuts to come and saying Friday’s measures were “just the beginning” as the government goes to great lengths in its attempts to encourage growth.
WHAT HAPPENS NOW?
Mujtaba Rahman, managing director for Europe at consultancy Eurasia Group, believes Kwarteng and Prime Minister Liz Truss are unlikely to change course despite a harsh reaction from investors.
“For now, they’re going to try to weather the storm,” Rahman said.
That leaves markets waiting for the Bank of England to step in and stop the bleeding.
“I think monetary policy is going to be the crucial short-term driver,” said James Ashley, head of international market strategy at Goldman Sachs Asset Management.
The central bank has given no indication that it will raise interest rates outside of its normal meeting schedule. James Rossiter, head of global macro strategy at TD Securities, said the Bank of England is probably discussing this option, but he may be concerned it could further damage the UK’s credibility with foreign investors.
It is more typical for central banks in emerging markets to intervene to defend their countries’ 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 tougher going forward, especially since its half-point interest rate hike. featured last week now it seems too small. Economist Mohamed El-Erian, an adviser to Allianz, told the BBC the central bank should raise interest rates “by a full percentage point to try to stabilize the situation.”
Meanwhile, a more fundamental problem could continue to fuel volatility. While the Truss government wants to boost demand to avoid a recession this winter, the Bank of England is trying to cool down the economy so it can curb faster price rises among the G7 countries. That tension will reduce confidence in the way forward.
“If the markets still don’t have faith in the fiscal picture, I’m not sure how the Bank of England wins this,” Rossiter said.
— Rob North contributed to this article.