British pound hits a 37-year low as UK economy skids

London(CNN Business) The British pound slumped to a 37-year low on Friday after new data showed that shoppers are pulling back spending as inflation squeezes household budgets, underscoring fears that the economy may already be shrinking.

The currency fell below $1.14, its lowest since 1985, after the Office for National Statistics said that retail sales in August dropped 1.6% month-over-month, the biggest decline since December 2021 and significantly worse than economists had expected.

"I think the UK is in recession already," said Michael Hewson, chief market analyst at CMC Markets UK.

The pound has been hammered by a string of weak economic data, but also the steep ascent of the US dollar, a safe haven investment that sees inflows in times of uncertainty. The greenback is now near its strongest level in about two decades against a basket of top currencies, bolstered by expectations of another big rate hike by the Federal Reserve next week.

But the economic outlook in the United Kingdom means the pound is suffering more than most. It's lost more than 15% of its value against the dollar this year, compared to a 12% decline in the euro.

A plan by Prime Minister Liz Truss to subsidize energy bills for households and businesses could ease the pain this winter, but may not be enough to restore growth. The Bank of England forecast a lingering recession before her plan was announced.

Investors have also been unsettled by indications that the government will pay for its energy program, which could cost as much as £150 billion ($171 billion), by sharply increasing the UK national debt. Chancellor Kwasi Kwarteng is expected to deliver more details next Friday.

The UK generally imports more than it exports. That means a weaker pound pushes up the cost of fuel, food and other goods, making it even harder for the Bank of England to get prices under control.

The central bank, which is due to make its latest policy announcement on Thursday, has been aggressively hiking interest rates in a determined bid to bring down inflation, which stood at 9.9% in August.

It now faces a huge dilemma: Another big increase in borrowing costs could weigh on the economy even more. Not keeping pace with the Fed, however, could push the pound even lower.

Hewson said he believes the pound will now fall toward $1.10 after breaking the $1.14 mark.