For now, the Bank of England has restored some calm to global financial markets, which grew jittery a week ago, after the new British government of Prime Minister Liz Truss and her Conservative Party announced a huge tax cut not financed. As economists and financial analysts criticized this policy as ill-timed and irresponsible, the value of the pound plummeted, as did the prices of British government bonds. In finance, however, the weight of money almost always wins. So when the Bank of England, which can create unlimited amounts of cash, Announced on Wednesday that it would buy UK government bonds “on whatever scale is necessary” to “restore orderly market conditions,” investors snapped up assets that had been treated as radioactive waste. In just a few hours of trading, 30-year British government bond yields, which move inversely with prices, jumped from 5.1 percent to 3.9 percent, a huge rally. The pound also stabilized. After hitting an all-time low of $1.035 on Monday, it was trading around $1.11 on Friday afternoon.
More specifically for Americans, US Treasury yields, which rose sharply during the sterling sell-off, have also fallen since the Bank of England intervention. Since interest rates throughout the US economy are pegged to Treasury bond rates, this is reassuring news for mortgage applicants, car buyers, and anyone else looking for a loan. As the Federal Reserve raised the fed funds rate to combat inflation this year, mortgage rates and other borrowing costs have risen sharply. The last thing the economy needs is a new rise in interest rates that is unrelated to the actions of the Federal Reserve.
This goes to the first lesson from last week’s events in the UK: the US economy is not insulated from international events. To be sure, its sheer size (in the second quarter of this year, gross domestic product was $25.25 trillion) and the fact that the United States is largely energy self-sufficient give us some protection against bad things happening. abroad, as he was in Ukraine. But today’s financial markets are so interconnected that shocks in other parts of the world can quickly spread to Wall Street. Many of the largest US banks, including JPMorgan Chase, Citigroup, and Bank of America, have extensive operations in London. If the fall in the pound had turned into a panic sell-off, accompanied by a total collapse in the British bond market, who knows what losses these banks would have suffered?
Not surprisingly, US officials have raised concerns about British tax cuts and their possible repercussions. According to Bloomberg NewsSome US Treasury officials have been working through the International Monetary Fund, the international lender and Washington-based watchdog, to pressure the Truss government to change course. Although the IMF is nominally an independent agency, the United States is its largest financier and wields great influence over it. In a rare public rebuke of a G-7 country, the IMF issued a statement on Tuesday calling on the British government to change course. (I contacted the Treasury Department and asked for a comment on the Bloomberg story, but there was none.)
The second lesson of the past week is that the US financial markets, and by extension the US economy, are in a particularly vulnerable position due to the removal of an important support: the will of the Fed. Federal to come to the rescue in response to a drop in stock prices or bond prices, or some other alarming event. This safety mechanism came into play during the 2008 financial crisis and again in early 2020, at the start of the coronavirus pandemic. Both times, the Fed cut interest rates and also opened its monetary spigot to buy financial assets that would otherwise have a hard time finding buyers, a policy known as quantitative easing. Right now, however, the Fed is pursuing the opposite policy: raising rates and selling some of the Treasuries and mortgage bonds it previously bought.
If an explosion were to occur in the US financial markets, the Federal Reserve could possibly follow the Bank of England’s lead starting this week and back down, at least temporarily. But, having spent the last few months signaling to markets how determined they are to reduce inflation, the Fed would be loath to change course. Investors know this, and that adds to the nervousness in the markets. Not surprisingly, Fed officials don’t appear to be big fans of Trussonomics. When asked earlier this week if the British tax plan announcement had increased the chances of a global recession, Rafael Bosticthe president of the Federal Reserve Bank of Atlanta responded, “It doesn’t help.”
The other lesson from the pound’s troubles is that most Americans don’t realize how lucky they are to have the dollar as their currency. Not only is it accepted in many parts of the world as a means of payment and a store of value, but its status as what economists call the international reserve currency also allows the United States to borrow heavily abroad even when the country accumulates more debt. . When other countries introduce expansionary fiscal policies that bear little relation to their future tax revenues, international investors tend to punish them by lowering their currencies, a lesson that Truss and Kwasi Kwarteng, the British Chancellor of the Exchequer, have just brutally learned. As the United States racked up more than $20 trillion in debt over the past twenty years, foreigners shook their heads but continued to accumulate dollar-denominated assets.
In early 2020, during the early stages of the pandemic, investors abroad, particularly in the Middle East and East Asia, sold Treasuries in large numbers, raising fears that the dollar’s special status could be threatened. Later in 2020, and particularly in 2021, foreign holdings of US government debt rebounded strongly, but fell again in the first half of this year. Unique factors have been cited for these developments, and indeed the recent strength of the US dollar suggests that there is currently no lack of appetite for dollar-denominated assets. But the pound’s woes should remind us that things can change.
During the 19th and early 20th centuries, the pound sterling was the international reserve currency. Then the dollar replaced it. Fortunately for Americans, a suitable replacement for the dollar has not been found: the greenback still reigns supreme. That situation could persist, but it will not last for eternity. If it ever changes, watch out. ♦