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Pound fall will worsen inflation and raise interest rates

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

Since Friday, when Finance Minister Kwasi Kwarteng formally announced the plans, the pound sterling has fallen 5% against the US dollar, bringing its total losses so far this year to 21%. The euro, for comparison, has fallen by around 15% against the dollar over the same period.

The turmoil does not end there. Investors have rushed to jettison UK government bonds as they worry about the extra 72 billion pounds ($77 billion) in loans due before April.

Yields on opposing 5-year debt have jumped from about 3.6% to more than 4.4% in the last two trading sessions – an astronomical leap in a corner of the financial universe that normally sees movements in small fractions of a one 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 end the chaos, the consequences of which will not be limited to the markets. The falling pound is terrible news for an economy that may already be in recession, as it makes it more expensive to import essential goods like food and fuel. That could add to decades-old inflation that is fueling a cost-of-living crisis for millions of homes.

Consequently, the Bank of England will come under pressure to raise interest rates even faster and faster. This would increase the cost of borrowing for businesses and individuals and leave less money for businesses 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 improving living standards for low- and middle-income families. He has been harshly critical of the UK government’s proposals.

Why the falling pound is bad news

The pound hit a record low against the dollar on Monday, falling close to $1.03 before rebounding to nearly $1.07.

When a currency loses value, it can be useful to manufacturers, making their exports cheaper. But given the broader economic climate, few would consider the sharp drop to be a positive development.

A major concern is what this will mean for paying for imports. The cost of energy is a particular concern as the weather turns cold.

Since commodities are normally paid for in dollars, a rising dollar and a falling pound sterling will mean higher prices for UK importers. And while countries in Europe are racing to stock up on natural gas as they try to reduce their dependence on Russia, the UK lacks similar storage capacity, leaving it even more exposed to prevailing market prices.

Then there are the rapidly rising borrowing costs for government, businesses and households. Investors expect the Bank of England to need to raise interest rates much more aggressively to control inflation. They are now projecting an increase in rates to around 6% next spring.

Rates haven’t been this high since 2000. Given that the central bank only started to hike in December, when rates were at 0.1%, the quick pivot could trigger a strong economic reaction.

“Rising interest rate expectations have already added another £1,000 a year to the next rise in mortgages for a typical borrower, while the pound’s fall means more expensive imports fueling higher inflation,” Bell said. People living in the UK would see a decline in living standards as a result, she added.

Halifax, owned by Lloyds Bank, removed some of its mortgage products, while Virgin Money stopped accepting mortgage applications from new customers until “later this week” because of wild market moves.

asking for calm

The turmoil in financial markets prompted the Bank of England on Monday to say it would review the effects of the government’s plans on inflation at its next meeting scheduled in November and “would not hesitate to change interest rates as necessary”.

The bank issued its comments shortly after the UK Treasury said Kwarteng would outline plans to ensure the UK’s medium-term debt sustainability on 23 November, and that the country’s budget watchdog would be asked to release an updated forecast. that moment.

It is unclear, however, whether these comments will be enough to reduce alarm among investors, who are concerned about the government’s unorthodox approach.

“It remains to be seen whether today’s statement from the government and the Bank of England will be enough to ease market fears about the government’s fiscal policy,” said Paul Dales, chief UK economist at Capital Economics.

Over the weekend, Kwarteng doubled down, suggesting more tax cuts are on the way and saying Friday’s measures were “just the beginning” as the government goes all out in its attempts to promote growth.

What happens now?

Mujtaba Rahman, managing director for Europe at consultancy Eurasia Group, thinks Kwarteng and Prime Minister Liz Truss are unlikely to reverse course, despite strong investor backlash.

“For now, they will try to weather the storm,” Rahman said. This leaves markets looking to the Bank of England to step in and stop the bleeding.

“I think monetary policy will be the crucial determinant in the short term,” said James Ashley, head of international market strategy at Goldman Sachs Asset Management.

The central bank has given no indication that it will raise interest rates outside of its normal meeting schedule. James Rossiter, head of global macro strategy at TD Securities, said the Bank of England is likely discussing such an option but may be concerned that it could further damage the UK’s credibility among foreign investors.

It is more typical for central banks in emerging markets to intervene to defend their country’s currencies, he noted, although Japan intervened last week to support the yen for the first time in 24 years.

The Bank of England will almost certainly have to be tougher going forward, especially as its half-point interest rate hike released last week now looks too small.

Economist Mohamed El-Erian, an adviser to Allianz, told the BBC that the central bank should raise interest rates “by a full percentage point to try to stabilize the situation”.

Meanwhile, a more fundamental issue may continue to add to volatility. While the Truss government wants to boost demand to stave off a recession this winter, the Bank of England is trying to cool the economy so it can contain faster price rises among the G7 countries. This tension will reduce confidence in the way forward.

“If markets still don’t trust the fiscal picture, I’m not sure how the Bank of England beats it,” Rossiter said.

Source: CNN Brasil

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