The pound dropped to $1.08. (Photo: via Associated Press)
People both inside and outside of Westminster were left wincing on Monday as the pound dropped to a record low not seen in almost 40 years.
After plummeting to around $1.03 (in US dollars) early in the morning, it had bounced up a little to £1.08 within 24 hours – but the rapid decline is still worrying many, including Tory MPs who previously backed Liz Truss.
It’s not just against the US dollar either, it’s currencies around the world, although this comparison with the States is the one most commonly used to understand the market.
This is often called a currency crisis – when the pound sterling rapidly loses its value against rivals – and will have a significant impact on the UK economy.
Pound v dollar (Photo: Press Association Images)
What caused the sudden drop?
The decline in value stemmed from Asian markets, which are several hours ahead of the UK, as investors lost faith in the UK economy and actually pulled their money out of British businesses.
That meant by the time people woke up in Britain on Monday morning, a dramatic shift had happened – seemingly overnight. Other markets then reacted similarly, although there was a small bounce-back.
It all came after chancellor Kwasi Kwarteng announced his drastic “mini” budget on Friday, which created the largest set of tax cuts seen in the UK for 50 years.
It did not come with an independent assessment of the UK’s finances via an Office for Budget Responsibility forecast either, making investors even more nervous.
Kwarteng has hedged his bets on expecting people to spend more money now there are fewer taxes, so the demand for good and service increases.
However, this also means that inflation will increase – and it’s already at a 40-year-high.
Kwarteng then seemed to fan the flames of worry for investors by promising more tax cuts to come during the weekend – triggering the low numbers we saw on Monday morning.
Investors are worried that Downing Street will try to pay for these tax cuts by borrowing more money, so there will be more national debt in the long-term.
Why does it matter?
For UK businesses which import goods, the cost of importing objects from overseas will increase with a weak pound.
When the pound is worth less, money for Brits who travel won’t go as far, and prices will increase for those who buy foreign goods.
Imported food will be more expensive, as will electrical goods, and consumer price inflation will start to increase again.
Why is the dollar so strong right now?
The dollar has been rising because the US central bank, the Federal Reserve, has been increasing interest rates to combat the soaring inflation rates on the other side of the Atlantic.
Rising interest rates means more capital comes into a country, and so increases the value of the dollar.
As Europe is more vulnerable to the energy crisis after building a dependency on Russian fossil fuel, the US is also able to get stronger in comparison.
As the pound’s value has dropped so dramatically, there are concerns there could soon be parity between the two currencies. This is when the US dollar and the pound would be the same price.
Pound v dollar (Photo: PA GraphicsPress Association Images)
Why do interest rates rise?
An interest rate explains how much it costs to borrow, or to save. If you borrow, the higher the percentage, the more you have to pay back. If you save, this is the other way around – you’ll receive more money for saving more.
The current interest rate is 2.25%, set by the Bank of England as a way to control inflation, which it has to keep under control.
Its target is 2% inflation, but that’s a long way off the 11% rate expected to kick in later this year.
Kwarteng’s announcement means interest rates could increase, making it more expensive to borrow money and so reducing the rate of spending.
If people and businesses then spend less, demand decreases and prices fall.
Higher interest rates mean there would be more savings deposited in the UK, meaning the value of the pound can increase – although it does have the knock-on effect of increasing borrowing for households and businesses.
The Bank of England has already said it won’t hesitate to raise interest rates by as much needed to get inflation back in hand, and has promised that it is following developments closely.
The next scheduled policy decision is on November 3, although if the market continues to decline at this rate, an announcement could come earlier.
UK historic inflation rate. (Photo: PA Graphics via PA Graphics/Press Association Images)
What does shorting the pound mean?
While the rest of the country panics, hedge fund managers are said to be profiting from the fall in value for the sterling by “shorting the pound”.
Short selling, as it is also known, is when investors borrow shares in a company they think will fall in value, then sell these to buyers at the current market price.
It is all hooked on guessing that the price will fall, so they can buy back the stock at a reduced rate before returning it to the company – while being able to keep the profit themselves.
This effectively means the investors profit when the value of the pound decreases. It tends to happen on foreign exchange markets, where currencies are converted into others.
How has the government responded?
Well, mostly with silence.
Truss and Kwarteng have refused to comment on fluctuating markets, with the chancellor even having an awkward (silent) encounter with broadcast journalists while trying to leave his office on Monday. He is reportedly considering making further changes come November, as the Treasury has promised to set out a medium-term fiscal plan this autumn to calm the markets.
Kwarteng is also said to be holding daily meetings with the Bank of England governor now, although he maintains that he is still “confident in our long-term strategy”.
Previous government have tried to soothe the market by vowing to cut civil servant budgets to balance out of the books.
Former chancellor and previous contender for Tory leadership, Rishi Sunak, had promised to bring down annual spending deficit and the country’s overall debt.
This article originally appeared on HuffPost UK and has been updated.