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Plunging pound may force Bank of England to raise interest rates to 3.25%

Pound Bank of England governor Andrew Bailey. Photo: Frank Augstein - WPA Pool/Getty
Bank of England governor Andrew Bailey. The pound fell to a record low as traders grapple with Britain's economic policy plans. Photo: Frank Augstein/WPA Pool/Getty

The pound (GBPUSD=X) tanking to a record low on Monday has raised the likelihood of the Bank of England raising interest rates by 1% sooner-than-expected.

Sterling collapsed to $1.0327 against the dollar overnight after tumbling 5%, taking it below its 1985 low and to the weakest since 1971.

The Bank of England (BoE) is reportedly preparing an emergency intervention after the currency crashed to an all-time low against the greenback. Threadneedle Street is expected to release a statement as early as today, the Telegraph reported.

Last week the BoE raised interest rates by 0.5% while warning that the UK is already in recession. That took the bank rate to 2.25%, the highest level since November 2008 – and experts have called for further action to stave-off pound losses.

Read more: Pound crashes to all-time low against dollar as Kwarteng signals more tax cuts

Mohammed El-Erian, advisor to financial service giant Allianz and president of Queens’ College, Cambridge, said the Bank should raise rates by 1% to 3.25% if chancellor Kwasi Kwarteng does not "recalibrate" the measures in his mini-budget that have thrown markets into a tailspin.

"If I were the governor and the chancellor is not modifying his plan, I would increase interest rates and not by a little, by 100 basis points, by one full percentage point to try and stabilise the situation," El-Erian told BBC Radio Four’s Today programme.

Financial markets had expected a more hawkish hike of 0.75%, which would have marked the biggest increase in 33 years.

Governor Andrew Bailey, Ben Broadbent, Jon Cunliffe, Huw Pill, and Silvana Tenreyro all voted to lift rates by half a percent, while Jonathan Haskel, Catherine Mann and Dave Ramsden pushed for a larger 75 basis point increase.

Read more: Kwasi Kwarteng announces biggest tax cuts since 1972 in UK growth push

However, since the UK finance minister announced his mini-budget on Friday, which includes a £45bn ($48bn) tax cut package, markets have reacted in shock to the government's "Growth Plan".

The measures, which are set to bring about the biggest tax cuts since 1972, have stoked fears that the new fiscal policies will send inflation and government debt soaring – and Kwarteng has hinted at "more to come" despite investor jitters.

In bond markets, yields on gilts (UK government IOUs) immediately jumped on the prospect of a big surge in government borrowing, and are on course for the biggest increase on record. To fund the stimulus, Britain's Debt Management Office lifted its government bond sales for this fiscal year by £62.4bn.

"The UK has planted a forest of magic money trees and the bond markets have taken a chainsaw to them all", Paul Donovan, chief economist at UBS Global Wealth Management said. "Any other economy, whose government is tending towards modern monetary theory must be considered vulnerable to a similar market reaction."

Read more: Mini-budget: 'Trussonomics' baffles investors as bonds and pound tank

Shadow chancellor Rachel Reeves said that she was "incredibly worried" about the pound's sell-off.

"I started my career as an economist at the Bank of England and like everyone else I'm incredibly worried about what we've seen, both on Friday with market reactions to the chancellor's so-called mini-budget, and also the reactions overnight," she told Times Radio. "It also puts more pressure on the Bank of England to increase interest rates."

Despite Kwarteng's ambitious 2.5% growth target, economists from Capital Economics estimate the measures will maybe add a small percentage to the current 1.4% growth rate to about 1.6%.

Read more: FTSE 100 holds up as tanking pound deepens economic worries

Russ Mould, investment director at AJ Bell, said: "The market’s continuing verdict on the mini-Budget which turned out to be anything but mini couldn’t really have been any more savage as sterling hit an all-time low against the dollar.

"The sceptre of parity against the dollar, which felt far off just a week ago, now feels dangerously close."

"The problem for the new government is the growth it hopes to engineer through tax cuts is unlikely to come through that quickly while the reduction in the buying power of the pound will effectively import more inflation at a time of already acute inflationary pressures.

"Government borrowing costs are also going through the roof – a key question facing investors in the face of all this is can and will Truss, Kwarteng and co. hold their nerve."

Watch: How does inflation affect interest rates?