The pound's crash will make inflation worse and push interest rates higher

London(CNN Business) The UK government's decision to implement the biggest tax cuts in 50 years while borrowing tens of billions of dollars to subsidize soaring energy costs this winter is a massive gamble that's sent shockwaves through financial markets.

Since Friday, when finance minister Kwasi Kwarteng formally announced the plans, the British pound has plunged 5% against the US dollar, bringing its total losses so far this year to an eye-popping 21%. The euro, for comparison, is down about 15% against the dollar during the same period.

The turmoil doesn't end there. Investors have raced to dump UK government bonds as they worry about the extra £72 billion ($77 billion) in borrowing due before April. The yield on 5-year debt, which moves opposite prices, has jumped from about 3.6% to more than 4.4% over the past two trading sessions — an astronomical jump in a corner of the financial universe that typically logs movements in tiny fractions of a percent.

The Bank of England said in an emergency statement that it was "monitoring developments in financial markets very closely," while the UK Treasury said plans to ensure the sustainability of government finances would be released later this year.

But that may not bring an end to the chaos, the consequences of which won't be limited to markets. A falling pound is dire news for an economy that may already be in recession, since it makes it more expensive to import essential goods like food and fuel. That could fan decades-high inflation that's stoking a cost-of-living crisis for millions of households.

Consequently, the Bank of England will come under pressure to jack up interest rates further and faster. This would push up the cost of borrowing for businesses and individuals, and leave less money for firms to invest and consumers to spend.

"This is a painful reminder that economic policy is not a game," said Torsten Bell, chief executive of the Resolution Foundation, a think tank that focuses on boosting living standards for low- to middle-income households. It has been sharply critical of the UK government's proposals.

Why a plunging pound is bad news

The pound hit a record low against the dollar on Monday, dropping near $1.03 before recovering to almost $1.07.

When a currency loses value, it can be helpful for manufacturers, making their exports cheaper. But given the broader economic climate, few would frame the steep drop as a positive development.

One big worry is what it will mean for paying for imports. The cost of energy is a particular concern as the weather gets cold.

Since commodities are typically paid for in dollars, a rallying greenback and falling sterling will mean higher prices for UK importers. And while countries in Europe have been racing to stockpile natural gas as they try to reduce their reliance on Russia, the United Kingdom lacks similar storage capacity, leaving it even more exposed to prevailing market prices.

Then there's the rapid rise in borrowing costs for the government, businesses and households. Investors expect the Bank of England will need to increase interest rates much more aggressively to get inflation in check. They are now penciling in a rise in rates to about 6% by next spring.

Rates haven't been that high since 2000. Given the central bank only starting hiking in December, when rates stood at 0.1%, the rapid pivot could trigger substantial economic whiplash.

"The surge in interest rate expectations has already added another £1,000 a year to the coming increase in mortgages for a typical borrower, while sterling's fall means more expensive imports feeding through to higher inflation," said Bell. People living in the United Kingdom would see a decline in living standards as a result, he added.

Halifax, owned by Lloyds Bank (LLDTF), removed some of its mortgage products, while Virgin Money stopped taking mortgage applications from new customers until "later this week" because of the wild market movements.

Asking for calm

The disorder in financial markets pushed the Bank of England on Monday to say it would look into the effects of the government's plans on inflation at its next scheduled meeting in November, and would "not hesitate to change interest rates as necessary."

The bank issued its comments shortly after the UK Treasury said Kwarteng would outline plans to ensure the sustainability of UK debt over the medium term on November 23, and that the country's budget watchdog would be asked to release an updated forecast at that time.

It's not clear, however, whether these comments will be enough to reduce alarm among investors, who are worried about the government's unorthodox approach.

"It remains to be seen whether today's statement by the government and the Bank of England will be enough to ease the markets' fears about the government's fiscal policy," said Paul Dales, chief UK economist at Capital Economics.

Over the weekend, Kwarteng doubled down, hinting of more tax cuts to come and asserting that Friday's measures were "just the start" as the government goes all out in its attempts to foster growth.

What happens now?

Mujtaba Rahman, managing director for Europe at the consultancy Eurasia Group, thinks that Kwarteng and Prime Minister Liz Truss are unlikely to reverse course despite the stark reaction from investors.

"For now, they're going to try to ride out the storm," Rahman said.

That leaves markets looking to the Bank of England to step in and stop the bleeding.

"I think monetary policy is going to be the crucial determinant in the short term," said James Ashley, head of international market strategy at Goldman Sachs Asset Management.

The central bank has given no indication it will hike interest rates outside its normal schedule of meetings. James Rossiter, head of global macro strategy at TD Securities, said the Bank of England is probably discussing this option, but may be worried it could further damage to the credibility of the United Kingdom among foreign investors.

It's more typical of central banks in emerging markets to step in to defend their country's currencies, he noted, although Japan intervened last week to prop up the yen for the first time in 24 years.

The Bank of England will almost certainly have to be tougher moving forward, especially since its half-point interest rate hike unveiled last week now looks too small. The economist Mohamed El-Erian, an adviser to Allianz, told BBC that the central bank should hike interest rates "by one full percentage point to try and stabilize the situation."

In the meantime, a more fundamental problem could continue to fan volatility. While the Truss government wants to boost demand to take the edge off a recession this winter, the Bank of England is trying to cool the economy so it can put a lid on the fastest price increases among G7 countries. That tension will reduce confidence in the path forward.

"If markets still don't have faith in the fiscal picture, I'm not sure how the Bank of England wins this," Rossiter said.

— Rob North contributed to this article.