The pound has dropped in value against other major currencies in the days since chancellor Kwasi Kwarteng’s first “mini” budget.
Now some economists warn UK interest rates could reach 6 per cent next year, which would be the highest level since 1999.
This would have huge ramifications for those with mortgages, or who are trying to buy their first home. At least six mortgage lenders have already said they temporarily can’t offer loans to new customers because they don’t know whether potential borrowers can afford them.
Tenants could also see their rents go up as landlords face higher costs to pay off their own mortgages.
So what’s behind the currency crash? Why could it lead to higher interest rates? And what might it mean for the cost of living?
Welcome to the FactCheck beginner’s guide.
Did the ‘mini’ budget cause the currency crash?
Both the pound and the euro have been declining against the dollar since Russia began its full invasion of Ukraine in February this year, which the new chancellor’s supporters have been keen to point out in his defence.
There are various reasons for this. The international markets feared that European nations would be more vulnerable to energy price crises (which so far, Europe has been), compared to the US, which is generally less reliant on buying energy from abroad.
Add to that the fact that the US Federal Reserve – the stateside equivalent of the Bank of England – has recently increased interest rates. That has made the dollar more attractive, for reasons we’ll get into later.
But the considerable fall in the pound that we’ve seen in recent days was not matched by an equivalent fall in the euro. And the steepest decline began in the minutes after Kwasi Kwarteng made his speech.
So while there may have been ongoing issues with sterling, it looks like the new chancellor’s announcements exacerbated them.
Why did the government’s announcements worry the markets?
It appears that the markets lost confidence in the UK economy because Mr Kwarteng announced an almost unprecedented – and unexpected – increase in government borrowing. (We knew some extra borrowing was coming, just not quite this much.)
Though the UK’s debt is lower than some major economies’, investors are often wary of putting money into countries that are increasing their own debt – especially by an amount that wasn’t previously predicted.
And while on paper the new chancellor’s massive tax cuts might increase UK GDP, there are fears that this will exacerbate the cost of living by driving up inflation.
All of this seems to have made the prospect of investing in the UK less inviting than it was before Mr Kwarteng stood up in Parliament on Friday.
Why are people talking about interest rates?
Interest is the reward you get for putting your money in a bank account and, conversely, the price you pay for borrowing money.
The “base rate” is the minimum interest rate that individual banks in the country offer savers or charge borrowers – though they can set their interest rates higher if they want.
The base rate is set by the central bank in an economy – in the UK, it’s the Bank of England.
If the Bank of England raises the base rate, investors get more return on their money if they put them in UK banks, which encourages international traders to buy sterling, and pushes up its price.
That’s partly why all eyes are on the central bank in the midst of this currency crash. In theory, the Bank of England could help reverse the pound’s downward trend by raising the base rate.
It’s expected to do this in November.
What does it mean for inflation?
Raising the base rate would also have another benefit: helping to keep inflation under control.
Making borrowing more expensive means fewer people take out loans, and people who already have mortgages have to spend more on interest payments – and therefore have less to spend in the wider economy.
This dampens down consumer demand for goods and services, which in turn reduces so-called “demand pull” inflation.
So if the crashing pound prompts the Bank of England to raise interest rates, could it ultimately lead to lower inflation and help solve the cost of living crisis?
Not so fast.
The UK relies heavily on importing goods from abroad. A weaker pound means UK companies have to spend more to buy those foreign products – and these extra costs are often passed on to the customer in the form of higher prices.
So unless and until higher interest rates increase the value of the pound, UK consumers may still find the price of everyday items is going up, not down.
And if interest rates push up the cost of mortgages, the cost of living will also be higher for the 6.8 million households that face higher repayments. (Though, to be clear, those on fixed rate mortgages would only see their costs rise once they come to remortgage at the new higher rates.)
The government is under pressure from around the world to keep the economy on track. The International Monetary Fund made a rare rebuke of the UK on Wednesday, saying: “given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture”. In other words, cutting taxes as Mr Kwarteng has done might make the cost of living crisis worse.