Why the pound has shot up while UK economy is struggling – expert Q&A
When Liz Truss and Kwasi Kwarteng’s tax-cutting mini-budget triggered a UK debt crisis in autumn 2022, the pound plummeted to almost parity with the US dollar.
- When Liz Truss and Kwasi Kwarteng’s tax-cutting mini-budget triggered a UK debt crisis in autumn 2022, the pound plummeted to almost parity with the US dollar.
- In 2023 the UK has endured weak growth, falling productivity and high inflation, yet the pound has been the strongest performing currency among the G10 leading economies.
Many thought last autumn that the pound would keep falling to dollar parity and below. What changed?
The Bank of England’s interest rate tightening is probably the key factor. Though also the government’s fiscal policy has been more restrained. Pound v US dollar 2021-23
But interest rates have been tightened in many countries. Why would it have made such a difference in the UK?
- The equivalent UK rate has gone up from just over 2% to 5%.
- Not only has the UK tightened more, the markets expect the Bank of England to keep tightening.
- Yet the pound has also gained against other currencies like the euro (rising from about €1.08 to €1.17 over the same period).
Why has the US dollar been losing value?
- The dollar is often seen as a measure of risk appetite – in other words, when the dollar is strong, there’s more pessimism in the global economy.
- The VIX index is evidence for this: it is a measure of how much fear is in the market.
- US inflation has been falling faster than in other countries, which all things being equal should cause the dollar to rise.
UK ten-year gilt yields are now higher than last autumn. Doesn’t that suggest sentiment about the UK has got worse?
- The rise in gilt yields since then reflects the rises in interest rates.
- UK 10-year gilt yields 2018-23
Is it unusual to see a currency strengthening so much when the economy is weak?
High inflation and rising government debt would normally be associated with a weakening currency, so the rising pound is not a reflection of UK fundamentals. It could reflect the fact that investors are expecting UK inflation to fall quickly, but that’s not what forecasts are saying. For example, NIESR (The National Institute of Economic and Social Research) thinks that inflation won’t return to 2% levels until 2025.
Many thought Brexit helped to cause the pound’s 2022 crash. Does the pound’s appreciation reflect investors feeling more optimistic about Brexit?
Probably the effects of Brexit on the pound were seen more in the one-off fall in 2016 after the referendum. The pound has never recovered to pre-Brexit levels. The pound’s performance over time
Who will win and lose from a stronger pound?
The winners will include consumers of imports and those travelling abroad, particularly to the US. Firms that buy goods in dollars will be benefiting. On the other hand, exporters are losing out.
Is it good news overall?
I would say so, yes. In general, it means that investor sentiment on the UK economy has improved and the gilt market has stabilised. It means there are net inflows into the UK economy (meaning more money is coming in than going out).
Where does the pound go from here?
- When last published in January, it suggested the pound was 12% undervalued against the US dollar.
- The question is whether the pound now keeps rising towards the sort of US$1.50 levels we used to see before Brexit.
- However, a rising pound is conditional on the public finances remaining healthy and inflation falling in line with expectations.