As the UK approaches its critical election next week, the outcome is poised to either rejuvenate or further destabilise the pound. The pound has experienced significant volatility since the Brexit vote in 2016, and the upcoming election represents a crucial juncture for the currency’s future. The economic landscape in the UK is fraught with challenges. Public debt is at a 63-year high, and foreign direct investment has seen a decline in four of the last five quarters up to the end of 2023.

These economic indicators highlight the urgency for coherent and effective economic policies from the next government. The Labour Party, led by Keir Starmer, is currently ahead in the polls, promising stability and a departure from the tumultuous political climate under the Conservatives. The key issue at stake is investor confidence. The pound’s recent rally reflects market optimism that a Labour government will bring the much-needed stability. However, this optimism is not without its caveats. Investors are acutely aware that Labour will need to balance its spending with prudent fiscal measures. The memory of the Conservative government’s missteps, particularly the mini-budget fiasco under Ms Liz Truss, which caused a market rout, remains fresh.

Labour faces the dual challenge of stimulating economic growth while managing a high debt-to-GDP ratio. To avoid austerity measures, Labour will likely need to increase taxes or borrowing. This delicate balancing act is crucial for maintaining market trust. If Labour can present and implement credible economic policies, it could bolster the pound by reversing the cycle of volatility and economic uncertainty that has plagued the UK in recent years.A predictable and stable fiscal policy from Labour could act as a tonic for the pound, much like the playbook of fiscal responsibility seen in other stable economies. The pound’s strength in recent months is, in part, a reflection of this anticipated stability. However, the exact policies that Labour will implement remain unclear, creating a knowledge vacuum that could lead to market jitters.

Analysts suggest that if Labour governs with a focus on stability and avoids excessive spending, the sterling could see a modest appreciation. Predictions indicate that the pound might climb to $1.2875 over the next year. However, there are significant risks if Labour’s policies swing too far to the left, potentially leading to inflationary pressures and adverse impacts on the bond markets and sterling. Moreover, the UK has been grappling with higher inflation compared to other G7 nations, with inflation peaking at 11.1 per cent in 2022. A 10 per cent depreciation of the pound could exacerbate inflation, adding 1.3 percentage points to consumer prices over two years. This underscores the importance of a balanced approach from the next government. A government that can instil confidence and predictability in the markets could reverse the negative feedback loop of economic policy uncertainty and financial market stress.