Why is the British pound falling significantly in summer 2022?

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Main topic: Humanities
Other topics: UK, British pound
Short answer:

The British pound has fallen broadly to investor concerns about:

  1. Tax cuts that will increase the budget deficit
  2. High inflation
  3. Insufficient rate hikes
  4. Weak economic activity (recession)

Tax cuts that will likely increase the budget deficit[edit]

On September 23, 2022, the Chancellor of the Exchequer of the United Kingdom, Kwasi Kwarteng, announced what has been referred by the media as "mini-budget".[1] The plan of new Prime Minister Liz Truss proposed, in summary, to:

  • Stop the new Health and Social Care Levy
  • Reverse the National Insurance April 2022 increase
  • Cut the Basic rate of the income tax from 20% to 19%
  • Eliminate the Additional rate of the income tax, effectively reducing its reduce from 45% to 40% (in England, Wales, and Northern Ireland)

On that date, the British pound fell 4% versus the U.S. dollar, to $1.09[2], having started the year at $1.35. This signals that investors and market participants did not like the UK proposal. Former U.S. Treasury Secretary Lawrence Summers called the policies "naive, wishful thinking, supply-side economics".[3]

Illustration of a British pound note on fire. Generated with DALL·E 2.

High inflation can lead to currency devaluation[edit]

By August 2022, UK consumer inflation has been rising at a 9.9% rate versus the previous year. The Bank of England, UK's monetary authority in charge of keeping inflation steady at close to 2%, said that it expects inflation to peak at 11% in October but still remain at around 10% for a few months.

UK inflation on August 2022; Bank of England.[4]

Expectations of high UK inflation versus other countries, especially versus the U.S., should lead to currency devaluation, according to an economic theory called Relative purchasing power parity (RPPP).[5] That is because differences in inflation rates lead to different in prices between countries. Absent price changes, the main way that these prices could return to parity is through currency devaluation.

Investors suggest that the BoE has not raised rates fast enough[edit]

Even after the U.S. Fed raised their base interest rate from 2.25% to 3.00% (75 basis points, bps), the UK Bank of England raised their rate from 1.75% to 2.25%, a lower level and a lower increase.

Interest rates hikes can stop currency devaluations by attracting foreign investment, but most investors suggest that the BoE's slower pace is not satisfactory. According to Credit Suisse, "[d]espite the improved interest rate outlook, BoE hikes are unlikely to support the GBP".[6]

Weak economic activity does not help[edit]

GDP change in Q1 2022 was estimated at +0.8%[7], while Q2 2022 GDP was estimated at -0.1%[8]. If Q3 2022 shows another decrease in activity, the UK will enter a technical recession, characterized by two quarters of negative GDP growth.

Historically, the British pound has never fared well in times of economic trouble.[9]

References[edit]

  1. ↑ "Liz Truss's Historic Gamble With the UK Economy Is Already Unraveling". Bloomberg. Retrieved September 26, 2022.
  2. ↑ Partington, Richard; Monaghan, Angela (2022-09-23). "Pound falls below $1.09 for first time since 1985 following mini-budget". The Guardian. ISSN 0261-3077. Retrieved 2022-09-26.
  3. ↑ Wearden, Graeme (2022-09-23). "Pound plunges through $1.09 as former US Treasury secretary blasts 'naive' UK policies in mini-budget– as it happened". the Guardian. ISSN 0261-3077. Retrieved 2022-09-26.
  4. ↑ "When will inflation come down?". www.bankofengland.co.uk. Retrieved 2022-09-26.
  5. ↑ "Relative Purchasing Power Parity (RPPP)". Investopedia. Retrieved 2022-09-26.
  6. ↑ "Article". www.credit-suisse.com. Retrieved 2022-09-26.
  7. ↑ "GDP first quarterly estimate, UK - Office for National Statistics". www.ons.gov.uk. Retrieved 2022-09-26.
  8. ↑ "GDP first quarterly estimate, UK - Office for National Statistics". www.ons.gov.uk. Retrieved 2022-09-26.
  9. ↑ "Sterling crisis: what are the historical precedents?". Economics Observatory. Retrieved 2022-09-26.
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