The pound faces a feared ‘doom loop’

As the numbers sank, sterling fell to a new two-year low, before recovering slightly on Friday. But the risk of stagflation in the UK, the appalling combination of skyrocketing inflation and economic stagnation last seen in the 1970s, now looms large. That is why some traders are predicting the first sustained drop in sterling below $1.20 since 1985.

And given how quickly the pound has fallen over the past month, there is even open debate about the possibility of the UK currency collapsing to near parity soon, with one pound equivalent to one dollar.

Sterling is under pressure, in part, of course, due to the strength of the US currency, which rose to a new 20-year high last week, amid concerns that the central bank’s actions to tackle inflation around the world will flatten global growth, boosting the price of the dollar. attractive as a safe haven.

US inflation actually fell slightly, we learned last week, to 8.3% in April, from 8.5% the previous month. As the world’s leading producer of food and energy, the United States is far less exposed than Western Europe to the economic fallout from the war in Ukraine.

Since the beginning of the year, the dollar has benefited from “flight to quality” investment flows anyway, as reasons to be nervous have increased: the impact of the omicron tension and the resurgence of restrictions on zero-Covid from China that slows growth in the world’s second largest economy, as well as the war in Ukraine.

It is notable, however, that the pound has lost ground since mid-April, not only against the dollar but also against other currencies, with the British pound falling around 3% against the euro.

Britain was supposed to be in the midst of a post-lockdown recovery, with the official 2022 GDP growth forecast at 6% at the end of March. Less than two months later, Britain is headed for the slowest growth and highest inflation of any G7 economy, amid mounting political uncertainty. As far as the forex markets are concerned, it’s an unattractive combination.

The recent sell-off in sterling came despite the Bank of England’s monetary policy committee raising interest rates earlier this month, for the fourth time in as many meetings, from 0.75 to 1 pc, the highest level in 13 years. A rate hike usually makes a currency more attractive given the higher yield, but the British pound tumbled.

The reason was that markets were expecting not a 25 basis point but a 50 basis point hike to 1.25%, along with a strong signal of many more rate hikes to come.

However, Governor Andrew Bailey and his team failed to achieve that, nor did they signal the start of attempts to rein in the Bank of England’s vastly enlarged balance sheet – the so-called quantitative adjustment – which offset at least some of the £875bn of easing. quantitative. seen since the 2009 global financial crisis. Half of that massive monetary expansion has occurred since the covid pandemic, and has been used in part to pay for licenses, business support loans, and other lockdown-related measures.

The reality is that financial markets are now unclear whether the Bank of England cares more about tackling inflation, which is supposed to be its mandate, or avoiding recession. After all, Bank officials spent months denying that inflation was a serious problem, referring to UK price pressures as “transient” even late last year, months after breakeven spreads and other signals from the markets warned that inflation would skyrocket.

That is why, as this column has often noted, the Bank’s credibility is now in serious question, along with its broader independence.

And, in times of crisis, that lack of credibility really matters.

The pound is now at risk of falling into a “fatal loop” as a lower pound results in more expensive imports, adding to upward price pressures. The resulting rise in inflation pushes the pound even lower, creating a downward spiral.

The United Kingdom is particularly susceptible to this danger, given its high dependence on imports. During the first quarter of this year, the goods and services trade deficit widened from £14.9bn to £25.2bn, according to official data last week.

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