How Great Britain got into a currency crisis

Experts say the UK government’s mini-budget or “tax event” over the past week is to blame for the turmoil. New Prime Minister Liz Truss and her Chancellor Kwasi Kwarteng had announced £45 billion ($75 billion) in tax cuts, mostly for high earners, and the market reaction has been brutal.

The pound fell as investors worried about a fiscal deficit escalation and the risk that tax cuts would exacerbate the UK’s inflation problem.

National Australia Bank’s head of foreign exchange strategy, Ray Attrill, says the magnitude of the tax cuts came “out of the blue” for international investors – who play a crucial role in funding UK government bonds. “International markets have fled at the potential financial and financial impact of the plan,” says Attrill.

Even before the shock movement, the British economy had inflation of 9.9 percent and a large current account deficit. The current account measures major transactions between an economy and the world, including imports, exports, and income streams such as dividends.

Markets feared that the tax cuts would push inflation even higher because when households get a tax cut, they have more money to spend. That is the opposite of what central banks – including the Bank of England – are trying to achieve by raising interest rates.

The rise in bond yields threatened to trigger a crisis in parts of the UK pension system as long-dated bonds play a role in defined benefit pension schemes. The Bank of England’s asset purchase program is a temporary move aimed at ensuring financial stability. But it still runs counter to the central bank’s goal of fighting inflation, according to AMP chief economist Dr. Shane Oliver states.

“You have this perverse situation where the Bank of England is loosening and tightening at the same time,” says Oliver.

What’s at stake?

The volatility could have a significant impact on the UK economy, causing government and household borrowing costs to rise.

The rise in bond yields is a sign that investors are anticipating aggressive rate hikes from the Bank of England as it tries to get its inflation problem under control. Its chief economist, Huw Pill, made it clear last week that there would be a “significant” response from the central bank at its next rate-setting meeting in November.

“Coupled with the macroeconomic implications of subsequent market developments, it is hard to avoid the conclusion that the fiscal easing announced last week will result in a significant and necessary monetary policy response in November,” Pill said.

Oliver says the Bank of England is expected to hike interest rates by around 1.25 percentage points at its next meeting. That’s more than double the Reserve Bank’s recent rate hikes.

“You have this perverse situation where the Bank of England is loosening and tightening at the same time.”

dr Shane Oliver, chief economist at AMP

The rapid change in interest rate expectations has prompted UK banks to withdraw hundreds of mortgage products due to difficulties in pricing their interest rates and forecasts of large house price declines.

What does this mean for the global economy and Australia?

UK market volatility made waves around the world, sending Australian bond yields higher last week, although they have since fallen.

AMP’s Oliver says an event like this wouldn’t normally have a global impact, but this time it did because markets are nervous about rising interest rates causing financial problems and investors “smelt a crisis”.

“The underlying problem globally is just restrictive central banks and high inflation, and the UK episode has only marginally added a sense of crisis,” he says.

Despite this, Australia’s direct economic engagement with the UK is limited as it is not a major trading partner despite the strong cultural ties between the countries.

Commonwealth Bank Head of International and Sustainable Economics Joseph Capurso says: “I see no long-term implications for Australian financial markets or the Australian economy. If it were China, it would be a big deal.”

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Brian Lowry

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