Liz Truss SCREENGRAB September 25 01
UK prime minister defends tax cuts as pound plummets
03:19 - Source: CNN
London CNN Business  — 

The UK government’s decision to implement the biggest tax cuts in 50 years while borrowing tens of billions of dollars to subsidize soaring energy costs this winter is a massive gamble that’s sent shockwaves through financial markets.

Since Friday, when finance minister Kwasi Kwarteng formally announced the plans, the British pound has plunged 5% against the US dollar, bringing its total losses so far this year to an eye-popping 21%. The euro, for comparison, is down about 15% against the dollar during the same period.

The turmoil doesn’t end there. Investors have raced to dump UK government bonds as they worry about the extra £72 billion ($77 billion) in borrowing due before April. The yield on 5-year debt, which moves opposite prices, has jumped from about 3.6% to more than 4.4% over the past two trading sessions — an astronomical jump in a corner of the financial universe that typically logs movements in tiny fractions of a percent.

The Bank of England said in an emergency statement that it was “monitoring developments in financial markets very closely,” while the UK Treasury said plans to ensure the sustainability of government finances would be released later this year.

But that may not bring an end to the chaos, the consequences of which won’t be limited to markets. A falling pound is dire news for an economy that may already be in recession, since it makes it more expensive to import essential goods like food and fuel. That could fan decades-high inflation that’s stoking a cost-of-living crisis for millions of households.

Consequently, the Bank of England will come under pressure to jack up interest rates further and faster. This would push up the cost of borrowing for businesses and individuals, and leave less money for firms to invest and consumers to spend.

“This is a painful reminder that economic policy is not a game,” said Torsten Bell, chief executive of the Resolution Foundation, a think tank that focuses on boosting living standards for low- to middle-income households. It has been sharply critical of the UK government’s proposals.

Why a plunging pound is bad news

The pound hit a record low against the dollar on Monday, dropping near $1.03 before recovering to almost $1.07.

When a currency loses value, it can be helpful for manufacturers, making their exports cheaper. But given the broader economic climate, few would frame the steep drop as a positive development.

One big worry is what it will mean for paying for imports. The cost of energy is a particular concern as the weather gets cold.

Since commodities are typically paid for in dollars, a rallying greenback and falling sterling will mean higher prices for UK importers. And while countries in Europe have been racing to stockpile natural gas as they try to reduce their reliance on Russia, the United Kingdom lacks similar storage capacity, leaving it even more exposed to prevailing market prices.

Then there’s the rapid rise in borrowing costs for the government, businesses and households. Investors expect the Bank of England will need to increase interest rates much more aggressively to get inflation in check. They are now penciling in a rise in rates to about 6% by next spring.

Rates haven’t been that high since 2000. Given the central bank only starting hiking in December, when rates stood at 0.1%, the rapid pivot could trigger substantial economic whiplash.