The timing could hardly have been more appropriate. On the 30th anniversary of sterling being ejected from Europe’s exchange rate mechanism, the pound came under renewed pressure on the currency markets and hit its lowest level against the US dollar in 37 years.
Black Wednesday – 16 September 1992 – has a special place in British postwar economic history: a moment in which the Treasury and the Bank of England took on speculators led by George Soros – and lost.
There will be no such dramatic shootout this time because the ERM debacle marked the end of Britain’s attempts to maintain the pound at a fixed rate against other currencies. Ever since, sterling has been allowed to find its own level.
Even so, its recent slide against its US counterpart has started to raise eyebrows in the financial markets, where there is increasing talk that it might approach one-for-one parity against the dollar for the first time since early 1985.
As was the case in the mid-1980s, the strength of the dollar is part of the story. In times of heightened uncertainty, there is a tendency for investors to park their money in the world’s main reserve currency, and a slowing global economy, rising inflation and the war in Ukraine have generated a risk-averse atmosphere.
Aggressive interest rate decisions by the US’s central bank, the Federal Reserve, have pushed the dollar even higher. After underestimating the strength of inflation, the Fed is now playing catchup.
Stronger than expected US cost of living data this week means the central bank is certain to raise interest rates by 0.75 percentage points next week, and some on Wall Street think it may opt for a full 1.0 percentage point increase. Higher interest rates make the dollar more attractive to investors because they get a better return on their money.
Yet while sterling is not the only currency feeling the heat, it has suffered more than most, and is now trading at its lowest level against the euro in more than 18 months. A falling pound makes UK exports cheaper but also makes imports dearer, putting upward pressure on inflation as well as making visits to the US more expensive.
There are three big factors driving sterling lower against the dollar. First, there is the state of the economy: it was notable that the trigger for the latest fall in the value of the pound was the release of official data showing spending in the shops and online fell sharply last month. Consumer anxiety about 10% inflation and rising energy bills is having an impact.
Second, the chancellor Kwasi Kwarteng is planning to set aside £150bn to cap domestic energy bills for the next two years. Britain is already running a hefty trade deficit and that is going to be matched by a much bigger budget deficit.
Third, hints from Liz Truss that she might change the inflation remit of the Bank of England together with the defenestration of the Treasury’s top official – Sir Tom Scholar – have made investors nervous about holding sterling.
Better economic news would ease the pressure on the pound, and the government will be anxious for evidence that its energy package is boosting consumer confidence and economic activity more generally. Parity against the dollar is by no means inevitable.
But as David Marsh, of the economic thinktank the Official Monetary and Financial Institutions Forum, puts it: “Liz Truss, in office for just 10 days, faces extensive challenges with loyal, largely untried ministers. Given the size of the UK’s budget and current account deficits and uncertainties over Truss’s economic and energy policies, there is a risk of major pressure on sterling that could disrupt her government.”
