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The British pound hit a low against the dollar on Monday after British Prime Minister Liz Truss, a fan of trickle-down economics, announced a sweeping plan for spending and tax cuts to save the UK economy from recession on Friday.
What is going on: Investors were surprised by the new government’s choice to implement its biggest tax cut in 50 years while ramping up government spending and borrowing at nearly 40 years of inflation. Citibank Analysts called the decision a “huge, unfunded gamble on the UK economy”. Markets fell steeply on the news.
But Truss took a cue from former US President Ronald Reagan as she defended her actions. The government “encourages companies to invest, and we also help ordinary people with their taxes,” she told DailyExpertNews’s Jake Tapper last week, referring to Reagan’s overflowing ideals.
So she’s right? Let’s dust off our history books and watch.
Interesting parallels: When Reagan arrived in Washington in 1981, inflation was close to 10% and tight monetary policy had pushed interest rates above 19%. But like Truss, Reagan argued that massive tax cuts and deregulation would boost productivity and argued for a sweeping tax cut passed by Congress that year.
The Truss government points to that as proof that cutting taxes doesn’t necessarily drive prices up. Inflation fell and growth rose under Reagan, it says.
But the policy had a price. According to estimates from the US Treasury Department, Reagan’s tax cuts cut federal revenue by about 9% in the first few years. Meanwhile, unemployment continued to rise.
Congress concluded that the sweeping tax cuts were unsustainable. With Reagan’s approval, it significantly increased taxes in 1982, 1983, 1984, and 1987.
A lesson from history: “When tax cuts are really too big to be sustainable, they are often followed by tax increases,” wrote David Wessel, director of The Hutchins Center on Fiscal and Monetary Policy.
And in the short term there is also a huge risk to its currency for the UK. The US dollar has appreciated during Reagan’s tax cuts as it benefits from its status as a global reserve currency. A strong currency helps contain inflation and makes imports cheaper. Britain, which sees record declines in its own currency, does not have that advantage.
It comes down to: The British pound is likely to bottom within three months, Goldman Sachs economist Kamakshya Trivedi wrote in a note Monday. “But if [tax] If policy does not ultimately change course, we would expect Sterling’s underperformance to continue for longer,” he said.
That’s bad news for markets around the world. S&P 500 companies with a global presence have been hit hard by the strong dollar and the weakening pound — about 30% of all S&P 500 company revenues are earned in markets outside the United States.
The last time Britain’s taxes were cut so sharply, there was rampant inflation, a massive rise in debt and ultimately an IMF bailout. “It’s hard to see how the pound can recover here,” Fiona Cincotta, senior financial markets analyst at City Index, wrote in a note. “Investors are quickly withdrawing from UK assets, and who can blame them?”
We know that the British pound is falling against the dollar, but what exactly does that mean?
A declining pound is bad news for an economy that may already be in recession, reports my colleague Julia Horowitz. As the value of the pound sterling falls, it becomes more expensive to import essential goods that are typically paid for in US dollars, such as food and fuel. That could fuel decades-long inflation that is causing a cost of living crisis for millions of households.
Then there is the rapid rise in borrowing costs for the government, businesses and households. Investors expect Britain’s central bank, the Bank of England, will have to raise interest rates much more aggressively to keep inflation under control.
Fundamental tension between the central bank and the UK government could also fuel volatility. While the Truss administration is looking to boost demand to push out a recession this winter, the Bank of England is trying to cool the economy so it can limit the fastest price increases among the G7 countries. that friction will diminish confidence in the way forward.
“If markets are still not confident in the fiscal picture, I’m not sure how the Bank of England wins,” Mujtaba Rahman, general manager for Europe at the consultancy Eurasia Group, said.
Global central banks are raising interest rates with no end in sight until high inflation is overcome, DailyExpertNews’s chief business correspondent Christine Romans reports. Here are five groups who feel the pain as a result.
linvestors: Judging by last week’s stock market action, Wall Street is waking up to the fact that the Fed will remain aggressive. Bond yields are rising, making equities look less attractive.
Then there’s the reduction of the price target of Goldman Sachs’ S&P 500, its fourth this year, from 4,300 to 3,600. That’s a whopping 16% discount. The gloom is palpable for equity investors. The road to a soft landing seems to be getting harder by the day.
home buyers: Mortgage rates have more than doubled from last year’s record low of 2.87% to just over 6% last week. That adds over $700 in monthly interest payments on the same home purchased a year ago.
Last week, Fed Chair Jerome Powell told me tenants would too feel the pain. “Hope for the best, plan for the worst,” he said of rent inflation. “You just have to assume that it will remain quite high for a while.
Car buyers: The average interest rate for a 60-month new car loan was 3.85% at the beginning of the year. It is now hovering above 5%.
The market to buy a new or used car is still confused due to pandemic-related problems in the supply chain. Higher interest rates make financing a car – if you can find one – even more expensive.
workers: Powell and the Fed have been clear that they will tolerate, and may even want, a higher unemployment rate in order to cool inflation. The US economy added 3.6 million jobs this year and restored all the jobs lost during the pandemic, but the Fed’s inflation crusade could lead to a loss of 1.2 million.
The Conference Board will release US consumer confidence data for September at 10 a.m. ET.
The US Census Bureau publishes new home sales at 10:00 a.m. ET.