Pound sinks to record low against the euro

In July, £1 would still buy $2; lower than its recent record of $2.11 set last November, but healthy enough for shopping trips to New York to make sense. Yesterday, sterling was trading at about $1.48, a six-year low. Macy's and Sachs of Fifth Avenue may soon notice a sharp decline in the number of British accents at the tills.

Our currency has also been bouncing along the bottom against the euro, which is now worth about 84p, its highest since the single currency was launched in 1999.

Suddenly the idea of parity – £1 = €1 – hoves into view. Broadly speaking, sterling has had a more violent battering in recent months than it endured after it famously fell out of the European Exchange Rate Mechanism on "Black Wednesday", 16 September 1992. The pound has fallen 25 per cent against the dollar and 15 per cent versus the euro this year. It has, you might say, had a bit of a pounding.

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The reasons for sterling's weakness are not difficult to see. To some extent, it is simply an adjustment to the way the pound has been overvalued for years: its fair value is about $1.50, according to the Organisation for Economic Co-operation and Development.

What's more, the UK is evidently headed for recession and the Bank of England is predicted to cut interest rates to historically low levels, maybe even below 1 per cent over the course of next year – the lowest level since the Bank was granted its charter in 1694. Such meagre prospective rewards for investors and the general belief that sterling assets have further to fall has prompted a sharp sell-off in the currency.

Both the Governor of the Bank, Mervyn King, and the Chancellor of the Exchequer admitted on Wednesday that the country was facing a sharp, if short, recession. Few independent economists believe the UK will recover quite as quickly as the authorities forecast – or that this country is well placed to cope with the downturn. The IMF says that the UK's will be the most marked contraction in output – down 1.3 per cent – among the major advanced economies. Unemployment stands at 1.8 million, and will almost certainly climb to two million by Christmas and three million by 2010.

Yesterday, Europe's largest economy, Germany, the engine of the UK's largest market, the eurozone, confirmed it had entered its worst recession in 12 years or more. Investors are also becoming alarmed by the size of the British Government's budget deficit, predicted by the Chancellor to top £90m before long. The prospect of a large quantity of UK government securities being issued to pay for the shortfall and various bank rescues has raised concerns about the way the economy is being run and longer term worries about inflation and growth.

There is also a positive dollar story. One of the consequences of the recent financial turmoil was a flight to safety, with short-term (one week, say, or one month) US Treasury securities, the favoured haven of international capital, with the reassurance of the US government behind them; the Swiss franc was another notable beneficiary of this trend. Sterling has not enjoyed that same prestige. The Australian dollar has also languished unloved, a victim of the fall in commodity prices and the slowing Chinese economy.

Should the depreciation of sterling turn into a rout, we may even see the current policy of aggressive cuts in interest rates by the Bank of England suspended, if not reversed. For the moment, the Bank seems content to watch sterling fall. Although economic theory teaches that a weak pound could lead to inflation, the very poor state of the domestic demand limits the scope of manufacturers and others to pass on price increases in the shops.

Nor has the pound declined by enough to transform our balance of trade. Export orders remain weak, despite the low level of sterling, because demand in Britain's main markets – the rest of Europe, North America, Japan and China – remains so feeble. It will, in other words, need an even more savage discounting of the dollar/euro/yen prices of Scotch whisky, Range Rovers and Richard Rogers' buildings to stimulate demand for them and generate more foreign exchange earnings.

However, the Bank of England has pledged to act if sterling's fall becomes uncontrollable. A pause in the Bank's policy of slashing interest rates would have a depressing impact on the wider economy – with house prices falling further, consumer confidence staying low and the credit crunch again restricting the supply of credit for businesses and consumers.

Against a basket of currencies weighted according to the UK' s trade, sterling is down about 20 per cent on this time last year, a "pretty hefty" depreciation, in the words of the Bank of England's Deputy Governor for Monetary Policy, Charles Bean.

It is one of the more severe of the many bouts of weakness the pound has suffered since the Second World War.

It may be many years before a shopping trip to Manhattan or a Swiss skiing break seems quite the bargain it used to be.