The British pound plunged to an all-time low against the US dollar this week. Here's what happened, and what it means.
- The British pound tumbled to an all-time low against the US dollar on Monday.
- The IMF warned the UK government its proposed tax cuts could undermine its inflation fight.
The British pound plunged to an all-time low of 1.035 against the US dollar on Monday. Traders were betting that looser fiscal policy would fuel inflation, prompt faster interest-rate hikes, and undermine Britain's already-shaky economy.
Chancellor Kwasi Kwarteng said Friday that he intends to scrap Britain's top income-tax rate of 45%, nix a scheduled rise in the national insurance rate, and abolish the stamp duty on property purchases of under £250,000. On Sunday, Kwarteng hinted there could be even more tax cuts coming.
His tax cut plan is aimed at boosting the ailing UK economy and reducing the risk of a severe recession. However, it's sparked fears of faster price increases, government debt that's out of control, and a worse downturn.
The IMF warned the UK government on Wednesday that a sweeping fiscal package could undermine the nation's efforts to beat back inflation.
"Given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture, as it is important that fiscal policy does not work at cross purposes to monetary policy," the organization said.
Some investors don't believe the impending tax cuts will be fully-funded, meaning the UK government's debt pile will grow. Critics also worry the cuts will fuel already-high inflation — which hit a 40-year peak of 10.1% in July — by boosting demand.
The Bank of England has already hiked its base rate to 2.25% from near-zero at the start of 2022, in a bid to slow price increases by encouraging saving over spending and raising borrowing costs. However, as Kwarteng's tax plan rocks markets, the central bank could be forced to raise rates even more aggressively, risking "stagflation" — where the economy slows sharply or contracts, unemployment rises, and inflation remains stubbornly high.
The dollar's appreciation and the pound's slump this year partly reflect the US Federal Reserve's series of aggressive interest-rate hikes, which has lifted the federal funds rate from virtually nothing to a range of 3% to 3.25%. This has spurred some investors to swap pounds for dollars in pursuit of better returns.
The US Dollar Index, which tracks the dollar against a basket of major world currencies, has gained 18% this year. The greenback's strength reflects better yields on US bank deposits than in many other countries, plus a brighter growth outlook for the US, given the war and energy crisis in Europe, and ongoing COVID-19 lockdowns in China.
The pound on Monday also fell to its lowest level against the euro since January 2021, bringing its total decline against the continental currency to 8% this year. The implication is that investors fear Kwarteng's policies could make the UK economy a laggard relative to the embattled European Union.
Meanwhile, the UK's economic outlook is being clouded by Russia's invasion of Ukraine, which has disrupted global energy supplies and driven up food and fuel prices. Brits are set for a lengthy cost-of-living crisis, given prices have jumped across the board and energy bills are set to skyrocket this winter.
The UK economy shrank last quarter, and risks remain of persistently high inflation and unemployment. There will now also be a larger and more expensive government debt load, and a weaker pound making imports more expensive.
So it's little wonder investors are fleeing the pound.
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