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Key Takeaways
- Excessive government spending is hurting the pound against the dollar.
- Price caps and record high inflation is also a factor for a weak pound.
- The U.S. dollar is rallying as investors seek a safe haven during economic uncertainty.
The British pound has fallen to levels not seen since the 1980s. While some can point to higher inflation due to supply chain issues around the pandemic and the Russia-Ukraine conflict, these are not the only issues. Much of the damage to the pound is self-inflicted. Learn more about why the pound has fallen dramatically and what the future holds.
Why has the Pound Fallen?
The British pound briefly reached near-parity with the U.S. dollar toward the end of September 2022. The pound reached $1.035 before inching back upwards, but it is still trading at near-historic lows against the dollar. Multiple factors have influenced the drop in value, and most of them look like they won’t have a resolution soon. As a result, the pound may not return to its normal trading range for some time, depending on the decisions made by the British government and the Bank of England.
In late September, the British government decided to cut taxes without making plans to compensate for the loss of revenue. These decisions were made even though various inflationary pressures were (and still are) harshly impacting the government and its citizens. Upon news of the tax cuts, investors lost confidence in the British government’s ability to maintain its economy and sold off their holdings in British assets in large numbers. The loss in value of the British pound sterling is one of the direct results of the lack of faith investors have in the British economy.
Record levels of government borrowing
The British government, led by the new Prime Minister Liz Truss, decided to give tax cuts to high-income earners by eliminating the top tax bracket. However, that plan has been scrapped by Treasury chief Kwasi Kwarteng due to public backlash. After revoking the plan, the British pound rallied to $1.12 USD, which is where it was before the announcement of tax cuts.
Even with the change of the Prime Minister’s plans, other measures are still moving forward, which include deregulating various industries and borrowing heavily to pay for a cap on household energy bills. Borrowing to pay for household energy bills could become significant as the U.K. puts price caps on the cost of energy that its citizens have to pay. The problem with the price caps is that someone has to pay the difference between the cap and the market rate; in this case, the government pays.
Other government initiatives include reducing levies assessed on home sales and abandoning a plan to raise the corporate tax rate. This comes on top of other macroeconomic issues that include flat economic growth, inflation at 40-year highs, and seven increases in the prime rate enacted by the Bank of England to slow down inflation.
Investors took a dim view of the government’s efforts to fix fiscal issues without a clear plan of action to show fiscal responsibility. The markets responded by engaging in a mass sell-off of British assets toward the end of last month, September 2022.
The core of the issue is that the government has yet to find a way to increase its revenue to pay for its spending on aid for energy costs, which have risen significantly thanks to the Russian invasion of Ukraine. There has been no sign that the British government will cut spending to compensate for the lack of revenue.
The British government is betting that the country’s economy will return to a state of growth within two years, which will increase investment. However, critics are comparing the current actions the Prime Minister took to those of her predecessor, Margaret Thatcher.
Ms. Thatcher oversaw fiscal policies that increased poverty, almost three million people were unemployed for years. Investors are doubtful that a return to these economic policies is advisable. They feel that this avenue is more likely to result in unsustainable amounts of debt for Britain.
Bank of England intervention
The Bank of England (BoE) intervened as best it could to counteract the spike in interest rates and the pound’s loss of value. The bank stated it plans to engage in large-scale purchases of government bonds to restore the market to normal operating conditions. The Bank of England started bond auctions during the last week of September 2022 and will continue them through October 14, 2022. As a result, the pound’s value rose slightly, and interest rates dropped.
The chief economist of the Bank of England, Huw Pill, has stated that the bank is taking an active role in pushing back against the government’s fiscal decisions. The sale of bonds to the market attempts to end quantitative easing and move into a period of quantitative tightening. This results in less money circulating through the economy. This tool is designed to reduce inflation alongside interest rate hikes.
Ultimately, the Bank of England is still determining if its efforts to stabilize the economy will be successful and is closely monitoring the situation. It plans to react in a fashion appropriate to the current economic signals using the tools and options it has at its disposal.
Brexit
Finally, even though the U.K. voted to leave the European Union in 2016 and finished the transition in 2020, the impact of that decision is still reverberating today. Not only did the British pound fall from $1.40 to $1.20 on the heels of the news, but investors are also still figuring out how the U.K. will survive financially after leaving the EU. Some studies report that Brexit is causing much of the higher living costs today.
Why is the U.S. Dollar so strong vs. the Pound?
Another pressure on the British pound is a strong U.S. dollar. Investors flock to the U.S. dollar as a hedge against a global economic crisis. Investors around the world view the dollar as safe due to the aggressive fiscal policies enacted by the Federal Reserve to maintain the relative stability of the U.S. economy. It also speaks to the strength of the U.S. economy as a whole when investors prefer the dollar over other currencies. Another factor in the dollar’s strength comes from different countries and companies putting their reserves in the dollar when there are economic uncertainties.
In contrast, a strong U.S. dollar impacts companies exporting goods or operating internationally. Commodities such as wheat and soybeans cost more to buyers in other countries, putting inflationary pressure on their economies. Multinational corporations see lower profits and the cost of goods that are made in America increases. Americans who travel to foreign countries will find their dollar goes farther in purchasing power, but the opposite is true for residents of other countries who want to visit us.
Bottom Line
The British economy is a mess, and there doesn’t seem to be a clear path to economic growth. At best, the U.K. needs to cool inflation to help the country navigate its current crisis. At worst, residents should prepare for even higher living costs, high rates of unemployment, and a central bank that will continue to intervene to keep the economy from collapsing.
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