Tumult in the U.K., by itself, is unlikely to push the weakening global economy into a recession, economists said. But the reaction to events in London reflects the fragility of investor sentiment amid pandemic, war and historic inflation.
“The global economy is very far out of equilibrium. So when you get a shock, the ramifications are much greater than they would be otherwise,” said Eric Winograd, senior economist with AllianceBernstein in New York. “A stiff gust of wind can blow the whole thing over.”
Monday’s upheaval was triggered by investor fears that British Prime Minister Liz Truss’s proposal to increase government borrowing to pay for tax cuts will worsen inflation, which is already near 10 percent. Market reaction to the U.K. growth plan released on Friday — which some analysts likened to President Ronald Reagan’s 1980s approach — has been seismic. Since Thursday, the yield or interest rate on the British government’s five-year bond has jumped by a full percentage point, an enormous move by bond market standards.
The U.K.’s crisis is largely homegrown, as a new Conservative government grapples with the economic fallout from the pandemic, rising energy costs and the lingering effects of the country’s withdrawal from the European Union. But the continuing swings in stock and bond values on both sides of the Atlantic are the latest sign that the Federal Reserve and other central banks have unleashed a fundamental change in the global financial climate by sharply raising interest rates.
Central banks in almost every major economy are tightening credit in hopes of cooling pricing pressures. Those higher rates are roiling currency markets and forcing investors to reassess the value of stocks and bonds that they purchased assuming interest rates would remain near zero.
“The global environment is now very, very different,” said Neil Shearing, global chief economist for Capital Economics in London.
Five Fed rate hikes since March have lifted short-term interest rates by three percentage points, drawing foreign investors to the dollar. The greenback is up more than 19 percent against a basket of foreign currencies so far this year, which should help reduce U.S. inflation by making imported products more affordable. But at the same time, the stronger dollar is causing problems for U.S. trading partners.
In the U.K., the pound fell early Monday to an all-time low of $1.03. The Bank of England, which raised its benchmark interest rate the day before the government issued its new stimulus proposal, resisted calls on Monday for a further emergency increase. Instead, the Bank of England issued a bland statement, saying it was “monitoring developments in financial markets very closely in light of the significant re-pricing of financial assets.”
The bank said it would make “a full assessment” of the government’s plan at its November meeting and would “not hesitate to change interest rates by as much as needed” to control inflation.
On Monday, the People’s Bank of China said it would make it harder for traders to speculate on the yuan’s continued decline against the dollar. The Chinese currency is approaching its lowest point against the dollar since the 2008 financial crisis.
Dollar strength also prompted the Japanese government last week to intervene in foreign exchange markets for the first time since 1998 to support the yen.
Developing countries that borrowed dollars from global banks face higher repayment costs as their currencies sink in value. Likewise, the dollar’s primacy in global energy markets means heavy importers of oil are watching their bills tick higher.
The U.K. episode comes as investors continue digesting the latest Fed rate hikes while bracing for similar moves this week by central banks in Mexico, Colombia, Thailand, Hungary and Nigeria. Bondholders worry that the Fed will need to raise rates much higher to defeat inflation, thus eroding the value of existing securities. And stock market investors fear that same aggressive monetary tightening will eat into corporate profits and send shares tumbling.
“The proposal has really increased uncertainty and really caused people to question what the trajectory of the economy is going to be,” Raphael Bostic, president of the Federal Reserve Bank of Atlanta, said in a Washington Post Live interview.
The pound’s slide works to the benefit of American tourists, as it allows their dollars to go further. But it is anxiety-producing for British households, which were already contending with soaring energy bills and rampant inflation. They may soon confront higher costs for imported goods and services, including fuel, vehicles and food.
Though Truss had pledged tax cuts during her leadership campaign, the scale of the cuts still shocked many economic observers. “In the current economic environment it is a huge gamble,” wrote Thomas Pope, an economist with the Institute for Government.
On Friday, Kwasi Kwarteng, the new chancellor of the exchequer, or finance minister, announced a package of cuts worth 45 billion pounds ($48 billion) — amounting to the biggest shake-up to the British tax system in 50 years.
It is also a major shift from the policies of Truss’s predecessor, fellow Conservative Party member Boris Johnson, who last year announced tax increases to help cover the costs of the coronavirus pandemic.
Under Truss, the government has slashed the top income tax rate of 45 percent for those making more than 150,000 pounds ($160,000) a year and scrapped the cap for banker bonuses — moves that will predominantly help more-affluent citizens in hopes that they will increase their spending.
In a broader-reaching measure, the government will cap energy bills starting in October — at a cost of 60 billion pounds for six months.
European governments are eyeing similar programs to insulate consumers from higher energy bills. But instead of borrowing money to fund the new spending, they are mulling tax increases on some energy producers. “The U.K. is very much an outlier,” Winograd said.
Investors say the British government’s tax-and-borrow plan is ill-designed and self-defeating. Pumping more borrowed money into the economy with inflation already near 10 percent will only cause prices to rise faster, they said.
Plus, the U.K. needs to attract foreign money to finance its trade and budget deficits. In the first quarter of the year, the U.K. ran an 8.3 percent current account deficit, the widest measure of the country’s trade performance, while the government also spent much more than its tax revenue.
“The market thinks they have unsustainable twin deficits,” said Marc Chandler, managing director for Bannockburn Global Forex. “And what it takes to get the foreign money to finance them is higher rates and weaker sterling.”
The pound’s drop comes about two months after the euro reached parity with the dollar for the first time in nearly two decades. The euro had been losing ground all year in part because of economic upheaval from the war in Ukraine that has disrupted food supplies and sent energy costs soaring around the world, especially in Europe.
Mike Riddell, a senior fixed-income portfolio manager at Allianz Global Investors, said the weakening pound is not “necessarily a symptom of European recession.” Rather, investors are starting to become skeptical of Britain’s ability to fight inflation.
“The scary thing is that the global economy is yet to feel the impact of all the rates hikes we’ve seen around the world in the last few months, because it takes about a year for monetary policy changes to have an impact on the economy,” he said in an email.
In many cases, a weaker currency may be advantageous, for example, in making British exports cheaper for consumers in the United States — and so a weak pound will boost overseas sales for companies that are export-oriented. But it means anything denominated in dollars, such as energy costs, will soar for consumers.
The new British government hopes that by slashing taxes and regulations, it will be able to generate growth that will help to fund public services and eventually pay down the debt.
John Hardy, head of foreign exchange strategy at Saxo Bank, said the pound was sliding because the government’s math isn’t reassuring investors.
“It’s a numbers game, and their numbers don’t add up,” he said.
Rachel Lerman in Washington contributed to this report.
