Why is value of the pound falling? Dollar pound ratio explained, what exchange rate change means for economy

The UK economy is plagued with uncertainty after Liz Truss’s Chancellor Kwasi Kwarteng unveiled major tax cuts that will force up government borrowing

The UK economy has been left reeling since Chancellor of the Exchequer Kwasi Kwarteng announced major tax cuts in his mini budget.

As well as being criticised for disproportionately benefitting the rich - a key element of the trickle down economics Liz Truss subscribes to - the government’s plans have also contributed to a major fall in the value of the pound. It hit record lows on Monday (26 September).

In an extraordinary intervention, the International Monetary Fund (IMF) has urged the Prime Minister to change course or risk even greater inflation and deepening inequality.

In a bid to stabilise the economy, the Bank of England has suggested major interest rate hikes are on their way. It has announced it will step in to buy up government bonds.

The value of the pound tumbled relative to the Dollar in August 2022 (image: AFP/Getty Images)

Kwasi Kwarteng has also attempted to ease market anxiety by meeting with key City of London institutions and insisting the government has a medium-term fiscal plan that goes beyond cutting taxes.

But why has the pound fallen in value by so much - and what does it mean for the general public? Here’s what you need to know.

How much has the pound fallen by?

The pound fell to a 37-year low in the immediate aftermath of the Chancellor’s mini budget. It dropped 2% against the dollar, falling below $1.10, making the dollar worth 92p.

But it tumbled even lower on the Asian markets on Monday morning (26 September). The UK’s currency fell to just $1.03 before rallying to $1.07 when European markets opened.

With the IMF’s intervention late on Tuesday (27 September), the pound has fallen back once again to $1.06 - making the dollar worth 95p.

It means the pound has fallen 10% since the end of August when it was worth $1.16 - although this was a six-year-low in itself. 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 €1.11. It had been €1.19 at the end of July 2022. The Euro has been trading close to 20-year lows against the dollar.

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Why is the pound dollar exchange rate falling?

The performance of a country’s currency is directly tied to its economic outlook. Put simply, investors are not optimistic that the UK is going to get inflation under control and see the economic growth Liz Truss thinks her tax cuts and de-regulation will provide.

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.

The Dollar has been performing strongly as the US could avoid a recession (image: Getty Images)

While forecasts have shown inflation will peak at a much lower rate than financial institutions like Goldman Sachs had predicted - largely as a result of the energy bills support packages for household billpayers and businesses - investors feel tax cuts will keep inflation higher for longer.

They expect the Bank of England will be forced to raise interest rates further in a bid to bring inflation under control. Some have even suggested the central bank’s base rate could go up as soon as next week.

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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 - currently scheduled for 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. To make matters worse, the Bank of England thinks the UK is already in a recession.

Another reason behind the pound’s 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 - especially given the fact that oil and gas are paid for using dollars.

In some cases, the rise in costs associated with the pound’s fall in value may take several months to pass onto the consumer.

The IFS warned the UK government was “betting the house” by cutting taxes by so much (image: PA)

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.