Nonsense does not make sense just because all mainstream news outlets repeat it.
It caused quite a frenzy in British media when the pound recently plunged to a historic low against the U.S. dollar. The BBC rushed to blame it on Chancellor Kwasi Kwarteng’s new tax policy:
The pound has fallen to a record low against the dollar as markets react to the UK’s biggest tax cuts in 50 years. … Chancellor Kwasi Kwarteng has promised more tax cuts on top of a £45bn package he announced on Friday amid expectations borrowing will surge.
Others piled on, among them Blain’s Morning Porridge, a widely read financial commentary. The ITV concurred, noting that it was the pound’s worst position vs. the dollar since 1971. They were also careful to explain that this happened “after Kwasi Kwarteng suggested another round of tax cuts.”
And here comes the shining jewel of echo-chamber journalism, a.k.a., The Guardian:
Kwasi Kwarteng has been accused of delivering a reckless mini-budget for the rich after his £45bn tax-cutting package sent the pound crashing to its lowest level against the dollar in 37 years.
It is tempting to dismiss the copy-paste news media’s pound plunge punditry as being simply uninformed. It would be even easier to follow in the proud tradition of the Left and call them all racists. After all, these are privileged white journalists going after Chancellor Kwarteng, a black man.
However, such easy escape routes only leave the nonsense dispensers looking like they hold the analytical upper hand. A far better route is to explain why they are wrong.
I understand that the British people felt a loss of pride when their sterling fell to almost parity vs. the currency of their erstwhile colonies. But there was no ‘crash’ of the pound, and it did not plummet vs. the dollar because Chancellor Kwarteng proposed big tax cuts.
There is a much simpler explanation: investors found a better place to park their money.
Let me offer six exhibits of evidence as to why the new chancellor’s tax plans are innocent. The facts of these exhibits are publicly available to anyone interested in looking for them.
Exhibit 1: The Bank of England interest-rate hike
On Thursday, September 22nd, the Bank of England raised its bank rate from 1.75% to 2.25%. The central bank explained its decision as a need to combat inflation and protect the value of the British currency:
Since August, wholesale gas prices have been highly volatile, and there have been large moves in financial markets, including a sharp increase in government bond yields globally. Sterling has depreciated materially over the period.
In effect, the Bank of England explains—correctly—that the British currency has fallen behind other currencies as central banks compete with each other on raising interest rates. This has incentivized investors to move money out of Britain, with a sell-off causing the pound to depreciate.
The BoE’s rate hike was meant to strengthen the pound. It was also meant to combat inflation and thereby restore confidence in the pound. The problem was the timing of the BoE rate hike: technically, the Bank could not do anything about the fact that its decision on the interest rate was scheduled one day after the Federal Reserve’s rate hike, but it could have done something about the size of the increase. While the Fed raised its federal-funds rate by 0.75 percentage points, the Bank of England stopped at 0.5 percentage points.
In other words, the BoE ‘lost’ the rate-hike match to the Fed. This puts downward pressure on the pound that adds an important piece to the explanation of the pound’s depreciation. It is not the whole explanation, but part of it.
What is not part of it is Chancellor Kwarteng’s tax policy. Here is more evidence to that effect.
Exhibit 2: The recent trend toward a weaker pound
If you want to talk about cause and effect, even in such quick-moving settings as financial markets, you better make sure you have the cause and effect rightly timed. Chancellor Kwarteng made the first announcement of major tax cuts on Friday, September 23rd. Yet according to data from xe.com, the pound began declining toward the dollar already on Monday that week, slowly depreciating through Wednesday.
This is consistent with what the currency and sovereign-debt markets would do if there were expectations of a substantial U.S. interest-rate hike. Which, again, came on Wednesday. The BoE rate hike on Thursday temporarily stabilized the pound, but it started declining again on Friday.
This decline coincides with Chancellor Kwarteng announcing his tax cuts, which as we saw earlier sparked the rumor that he was responsible for the currency’s depreciation.
To see why this is wrong, we dig deeper into the exchange-rate statistics over at xe.com. Their data is of particularly high quality, in part because they use so-called mid-market exchange rates. These rates, which are the midpoints between the rates that buyers and sellers get when they trade in a currency, eliminate any statistical bias toward either buyers or sellers. This means that the xe.com data is free of distortions from large, sudden exchange-rate shifts. Their data give us an accurate picture of the market trend.
Figure 1 reports the exchange rate for the dollar vs. the pound sterling over the week from September 19th through September 26th. The dollar starts the week at a rate where $1 buys just over £0.87, then it rises slowly through Wednesday. Thanks to the Bank of England raising its bank rate, the dollar-to-pound exchange rate stabilized on Thursday—temporarily, as it turns out:
The spike on Friday is followed by another spike on Monday the 26th. These two could easily be mistaken as being caused by Chancellor Kwarteng’s tax-cut announcements.
If that were the case, though, the pound would not have regained its Monday loss. But still—is this not evidence that the media reports are correct?
For the following reasons, the answer is no.
Exhibit 3: Switzerland
The Swiss central bank also raised its key interest rate on Thursday, September 22nd. It motivated its 0.75 percentage-point increase as necessary to counter “the renewed rise in inflationary pressure and the spread of inflation to goods and services that have so far been less affected.”
What happened to the Swiss franc? Well…
Look at that. The dollar strengthens against the franc in a pattern eerily similar to that which befell the pound. The first jump in the exchange rate happened on the day after the Federal Reserve raised its interest rate; the second leap happened on Monday the 26th.
For reference: British tax cuts do not apply in Switzerland.
Exhibit 4: Sweden
The Riksbank, the Swedish monetary authority, was ahead of the curve in the week of September 19th. It raised its lead rate because, the bank explains, inflation is higher than what the economy can handle. This calls for tighter monetary policy, the Riksbank said, and raised its lead interest rate by a full percentage point to 1.75%.
The Riksbank also explained that they predict raising the rate further in the coming six months.
So what happened to the exchange rate between the dollar and the Swedish krona?
As the week unfolded, one U.S. dollar bought more and more of the Swedish krona, just like it did with the pound and the Swiss franc. And just like those two currencies, the krona was subject to a fair amount of volatility on Monday the 26th.
For reference: British tax cuts do not apply in Sweden.
Exhibit 5: Norway
The Bank of Norway also wanted to be part of the rate-hike party, but they stopped at a 0.25 percentage-point increase that took their governing interest rate to 2.25%. Like the Swedes, they referenced inflation as a motivating factor, both for raising the rate and for the relatively modest increase:
Inflation has risen rapidly over the past months and has been far higher than projected. The labor market is tight, but there are now clear signs of a cooling economy. Easing pressures in the economy will contribute to curbing inflation further out.
Now let’s see what happened to the Norwegian krone in that rate-hiking week of September 19-26:
Exhibit 6: The euro
In a speech on September 20th, European Central Bank president Christine Lagarde explained that the central bank of the euro zone expects “to raise interest rates further over the next several meetings.” They did not make any changes to their interest rate in the period examined here—they had no meetings scheduled for monetary policy purposes—yet look what happened to the dollar-to-euro exchange rate:
With the exception of the euro, these exchange-rate examples are from currencies where the central bank raised interest rates in the week of September 19th. The euro adds a nice twist, demonstrating that in terms of its exchange rate to the dollar, there was no material difference between the currency of a central bank that raised its interest rate, and one that did not.
Admittedly, the euro is a lot bigger than the Scandinavian currencies, but apparently, that made no difference to the investors who sold European assets and currencies in favor of dollar-denominated equity. The big rate increase by the Federal Reserve simply created an irresistible opportunity for investors to make some good money, and do it safely.
This opportunity consists of two parts, the first of which is the return on securities issued by the U.S. Treasury. Those yields have risen sharply in a relatively short period of time. On Tuesday, September 27th, the yield on U.S. government securities exceeded 4% for almost all maturities; the ten-year treasury note fell just short of that threshold at 3.97%, and treasury bills maturing in six months or less paid 3.91% or less. Other than that, the yields are now above 4%, making it easy for investors to piece together a portfolio that returns 4% per year at practically no default risk.
By contrast, the persistent noise about another debt crisis in Greece makes investors more reluctant to hold euro-denominated debt. The growing worries about the euro-zone economy add insult to injury.
Furthermore, the rise in U.S. sovereign debt yields has been rapid, driven in good part by the Federal Reserve gradually reducing its holdings of said debt. As recently as April 8th, no U.S. treasury security paid even 3% on an annual basis. September 15th was the first day since 2011 that any U.S. debt instrument of any maturity paid 4%. Since tightening money determines the Fed’s monetary policy, yields will likely remain high. Therefore, even Treasury bills with short maturities become attractive investment opportunities: you can safely plan to roll them over without any expectation of losing yield.
The gradual strengthening of the dollar adds a bonus for international investors. The Fed’s promises of more rate hikes drive expectations of an even stronger dollar. This adds a bonus on investments:
1. You have £1 billion. At a one-to-one exchange rate, you buy $1 billion and invest it in one-year U.S. Treasury bills at 4% yield.
2. After one year you buy pounds again and bring home £1.04 billion.
3. Suppose instead that the dollar rises by 5% against the pound. When your U.S. Treasury securities mature and you get your $1 bn back, you can now buy £1.05 billion. But you also earned 4% interest on your securities. Adjusted for the new exchange rate, this income is worth £42 million. You earn a total of £92 million.
Blame these market mechanisms for sucking money out of Europe. Don’t blame Kwasi.