Financial markets and the British pound reacted strongly after Prime Minister Liz Truss’ government announced new tax and spending cuts.
The British government has launched a tax cut plan that is considered to be the most daring in the UK since 1972, along with a large-scale debt plan. Accordingly, the financial markets immediately reacted strongly and the pound also dropped to a record low.
New measures were introduced to boost economic growth. However, the budget level announced on September 23 raised concerns that the new Prime Minister Liz Truss’s plan could make inflation more stressful, affecting the financial ability of the government countries and even creating negative developments for the British pound, putting pressure on the Central Bank.
Why does the British pound depreciate?
The tax cut plan is not in the forecast of economists. Accordingly, the highest income tax rate for corporate and other taxes will be reduced. Ms Truss argues these changes will boost the economy, stave off a recession and lift Britain out of a decade of stagnation.
The plan announced by UK Finance Minister Kwasi Kwarteng includes an initial £200 billion ($250 billion) government spending to cut taxes and support gas and electricity costs for households and businesses. for six months, starting in October. Immediately, the pound fell more than 3%, to its lowest level since 1985. Two days later, he commented that the government “still has a lot more plans to do.” The pounds against the US dollar fell another nearly 5% to an all-time low of $1.0350, then recovered to $1.07.
The British pound fell to an all-time low after the British government announced plans to cut taxes.
UK economy context
The market is concerned that the government’s heavy spending on the fiscal stimulus plan will add to price pressure, as the Bank of England (BOE) is trying to contain inflation. Inflation in the UK was at 9.9% in August, nearly five times the central bank’s target and almost a 40-year high.
Investors are also concerned that the budget the government plans to spend will push the country’s debt situation into an unsustainable state. The UK’s financial conditions are already strained following the emergency spending in response to the pandemic, accompanied by soaring energy prices and costs associated with the Brexit vote.
Meanwhile, Britain’s economic output is at multi-year lows relative to other countries in Europe.
What are the UK government’s goals?
The purpose of tax cuts is to create a more dynamic economy, which then increases tax revenue and continues to control debt activity.
The plans of the Conservative-led government have received many comparisons to former Treasury Secretary Anthony Barber’s 1972 similar spending plan, resulting in a spiral of “wages and inflation” occurring.
Two years later, the Labor Party came to power, Mr. Edward Heath became the new Finance Minister and Britain had to rely on the support of the IMF in 1976.
Outlook for the UK economy
An export power like Japan can weather a falling currency thanks to a large current account surplus. The UK is one of the countries with the largest current account deficit in the world, while the budget deficit is also very large. This puts the UK in a position similar to that of some emerging markets.
Investment in domestic property and other asset classes is likely to help lift the pound in normal years. But as growth slows and the economy becomes increasingly unstable, many investors are reluctant to invest in this market.
Lawmakers from Ms. Truss’ party said the BOE may need to step in with an emergency rate hike to ease market tensions.
Why is the movement of the British pound so important?
Ms. Truss’ Conservative Party will have the nearest general election in 2025. That gives her more than two years to convince voters that her policies will work and the cost of living crisis in her country. You will reduce stress levels.
Although she retained a majority of votes in the House of Commons, her party trailed Labor in opinion polls. Meanwhile, a falling pound will put more pressure on the government. Based on the developments in the options market at the end of September, the pound will likely trade against the dollar by the end of 2022.
Refer to Bloomberg