Why is value of the pound falling? GBP-USD ratio explained, what UK currency value change means for economy
The UK economy is predicted to fall into a recession amid a major cost of living crisis
The UK finally got to hear what new Prime Minister Liz Truss’s plans for the cost of living crisis and UK economy on Friday (23 September). Her Chancellor of the Exchequer Kwasi Kwarteng unveiled a major package of tax cuts and de-regulation in his mini budget.
Policies included a cut to corporation tax, a reversal of a national insurance hike imposed by Rishi Sunak, and what was effectively a cut to stamp duty. More controversially, the Chancellor decided to scrap the cap on bankers’ bonuses while also announcing a clampdown on universal credit claimants.
It was a fiscal event that underlined Liz Truss’s belief in trickle down economics. This idea was criticised by US President Joe Biden, and has not proven popular on the markets as the pound slumped in the wake of the mini budget.
But why is this happening - and what does the fall in the pound’s value mean? Here’s what you need to know.
How much has the pound fallen by?
The pound has fallen to a 37-year low in the wake of the mini budget. It has dropped 2% against the dollar, falling below $1.10. It means a dollar is now worth 92p.
This is well below where the was at the end of August when it was worth $1.16 - although this was itself the pounds lowest value against the dollar for six years. At the beginning of 2022, £1 was equal to $1.35.
The pound has also fallen against the Euro, with the European currency now worth roughly €1.12. It had been €1.19 at the end of July 2022.
Why is the pound falling in value?
The performance of a country’s currency is directly tied to its economic outlook. Put simply, investors are not optimistic that the UK economy is going to reach the heights Liz Truss thinks it will under her leadership.
Currencies lose value when confidence in them falls and fewer transactions take place - something that also means the economy is unlikely to be performing as strongly. Here in the UK, the cost of living crisis means people across the UK are cutting back on spending - something that is also bad for businesses.
While forecasts of how high inflation will peak have improved since the Truss administration unveiled its energy bills support packages for household billpayers and businesses, the Bank Of England believes the UK is already in a recession, which has dampened business confidence.
Matters have been worsened by expectations that the huge tax cutting spree announced by Kwasi Kwarteng in the mini budget will force the UK’s central bank to increase the interest rate from what is already a 14-year high. This is believed to be necessary by the markets because tax cuts are likely to keep inflation higher over a longer period.
Bloomberg data shows UK interest rates are expected to hit 5.2% in August 2023, with a growing likelihood that a percentage-point interest rate hike will be implemented by the Bank of England at its next Monetary Policy Committee meeting in November 2022.
Higher interest rates means the cost of borrowing money goes up, which in turn lowers economic output as businesses feel less able to expand and invest in their operations.
Another reason behind the pounds fall against the dollar has been the strength of the US economy. As a major producer of oil and gas, it is not exposed to the same inflationary pressures Europe is exposed to as a result of its reliance on Russian energy imports.
What does a fall in the pound mean?
When the pound drops in value against other currencies, the most notable change for most people comes when they travel abroad.
Historically, the pound has been more valuable than most other major currencies. It meant that British tourists and businesses could spend less on more when making purchases on foreign soil.
But now, the pound has pretty much become like-for-like with the Euro and the Dollar. Given the UK is a net importer of food and fuel, a weaker pound means prices are more likely to go up - although the rise in costs will probably take several months to pass onto the consumer.
The biggest problem with a weak pound is at government level. Kwasi Kwarteng announced tax cuts worth £45 billion a year by 2026 in his mini budget, with a Treasury document estimating that these cuts and policies like the energy price guarantee would require public borrowing to rise by £72.4 billion.
The Institute for Fiscal Studies (IFS) reckons borrowing could remain as a high at £110 billion a year for several years - more than double what it was in 2019 (the last ‘normal’ year before the Covid pandemic). It said it expects taxes will have to rise and spending cuts introduced in future to pay for increasing the national debt by so much.
This borrowing will cost more money because the pound is weak. According to reporting by the FT, long-term borrowing costs have risen by their largest amount since 1998.
With the government set to issue a massive amount of new bonds - bonds (or gilts) being the way the government ‘borrows’ money from investors - their value will fall, meaning the government can raise less through this strategy.