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Bank of England’s wait-and-see approach unlikely to calm nerves

<span>Photograph: Maja Smiejkowska/Reuters</span>
Photograph: Maja Smiejkowska/Reuters

After a day of wild speculation in the City of London that left the pound in apparent freefall, the Bank of England had little choice but to break its usual silence on day-to-day currency market movements.

Sterling had plunged overnight in Asia to its lowest level in history against the US dollar, in a punishing verdict on Kwasi Kwarteng’s £45bn of unfunded tax cuts announced last week.

The resulting Threadneedle Street statement was, however, a far cry from the cavalry arriving to help Britain’s increasingly battered currency. Some investors were betting on an emergency interest rate increase to shore up confidence. Instead, the Bank’s governor, Andrew Bailey, said events were being monitored closely. The message was the markets could wait. The Bank’s next monetary policy committee (MPC) decision would not come until November.

The pound had been recovering some ground before the intervention only to resume a sharp selloff afterwards.

An emergency rate increase may never have been likely, given the proximity to Kwarteng’s mini-budget. Such a move would have been a political hand grenade from the Square Mile to Westminster at a time when Bailey is already under intense pressure from politicians questioning his leadership.

The Bank will hope that the initial dislocation in markets as investors digest the implications of Kwarteng’s tax cuts eventually subsides. Yet with blood in the water, and sharks circling the currency, the danger is growing that the Bank, and the government, are losing control of events.

That uncertainty was reflected by the subsequent resumed fall in the pound, touching $1.06, and a further rise in the cost of government borrowing to the highest levels since 2008. Britain’s credibility to make good on its commitments as a counterparty to investors is clearly now at a historic low.

Part of the story of the pound’s weakness is a function of dollar’s strength, but that does not explain why sterling has fallen so rapidly since the end of last week. There are three UK-related factors behind the fall.

First, once a currency hits the skids it is hard to stop it. Momentum trading took over after the mini-budget and has proved hard to halt.

Second, Kwarteng committed a schoolboy error by pledging further tax cuts over the weekend in a full budget planned for later this year. If the markets are worried about the state of the government’s finances and the increase in borrowing needed to fund your plans, it is not the wisest course of action to add to those concerns.

Third, the financial markets are still far from clear about how the Bank of England will respond, as reflected by the pound’s gyrations on Monday as excitement over a promised intervention was followed by disappointment at it being just a statement of intent.

As set out by analysts at the Bank of America, the situation is only likely to worsen. “[The] policy backdrop is toxic and is pushing [the pound] towards existential crisis,” they said, warning that interest rates would probably need to rise above 5%. Kwarteng’s budget would do little to boost growth, they warned, but would come with a hefty cost for the public purse, and add to severe inflationary pressures already ripping through the British economy.

Having stopped short of a rate increase this week, investor speculation is however likely to resume that the Bank may be forced to take action before November.

Some economists believe MPC members will make tough comments this week about the need for further rate rises, which could help to support the pound. Huw Pill, the Bank’s chief economist, is the most likely to take such steps in a pre-planned event on Tuesday.

There will be other opportunities for interventions later in the week. On Wednesday, Jon Cunliffe, one of the Bank’s deputy governors, is due to speak, albeit on central bank digital currencies. Dave Ramsden, another of Bailey’s deputies, will speak on Thursday, while two external members of the MPC, Silvana Tenreyro and Swati Dhingra, will also speak this week.

As in politics, a week is a long time in economics. Five weeks could prove an untenable period for Threadneedle Street to stay put.