'A weak currency arises from a weak economy, which in turn is the result of a weak government." That was Gordon Brown, speaking in the wake of the exchange rate mechanism debacle in 1992. Today, sterling has never been weaker. Its 25% decline on a trade-weighted basis since June 2007 is the steepest on record. Of the 17 currencies that make up its trade-weighted basket, sterling has fallen against all but the Icelandic krona, the South Korean won and the South African rand. Sterling has even fallen against the Hungarian forint - a currency that has already received two dollops of IMF aid. This may well be the first truly global recession of the modern age, but the inescapable fact is that it is also a sterling event.

Far smaller declines have in the past prompted so-called sterling crises - by our reckoning there have been seven "crises" since 1945. This could be the eighth. Should the UK authorities be worried? In our view, the answer is yes.

A weaker currency is not necessarily a bad thing. It makes home production relatively cheaper than foreign production. It can help sow the seeds of recovery by providing an escape valve for countries in deflation and in need of rebalancing. But you can have too much of a good thing: ask any Icelander. The majority of sterling's 25% decline since mid-2007 can probably be attributed to a rise in the risk premium - that is the extra reward, over and above its rate of interest, overseas investors require in order to be persuaded to hold a currency. This probably reflects a widespread loss of confidence in the UK's tripartite policy framework. But it also likely reflects a fear that the framework may not be capable of delivering the stability it was once thought to have enshrined.

In order to know whether sterling's decline is cause for worry or cheer, we need to examine its causes. Research commissioned by the Monetary Policy Forum suggests sterling may have moved to a permanently lower level, reflecting a preference shift away from what the UK was thought to do best: financial services. We attribute about 30% of sterling's decline to this factor. The drop in UK rates to levels not seen for 300 years has also played a part, explaining about 10% of the move. But our results suggest roughly 60% of the explanation lies in a higher risk premium.

Put plainly, the UK and its currency are now perceived as a riskier bet. Sterling's decline may be telling us that overseas investors see a significant risk of inflation ahead. It's not hard to see why. It took the Bank of England far too long to appreciate the potential damage the build-up of household debt and the associated bubble in house prices might cause. The ensuing crisis has forced the banking system into the government's arms, pushing up net government debt, which Brown pledged to keep always below 40% of GDP, to well over 100%. History teaches us that governments deep in debt are more likely to tolerate higher inflation. And this week the Bank of England began creating money in order to buy some of this outstanding debt - in effect monetising the deficit.

And yet, according to the latest forecast from Threadneedle Street, there is almost no chance of inflation breaching its 2% target before the end of 2012. In our view, this is not credible. We believe the UK authorities are downplaying the risk of high and volatile medium-term inflation. And that in itself further underlines the risk to investors of holding sterling. If that perception is allowed to become a self-fulfilling prophecy, Britain will be the poorer for it.

• DeAnne Julius was a founder member of the Monetary Policy Committee; Danny Gabay is a former chief UK and European economist at JP Morgan. Both are members of the Monetary Policy Forum: Mpf.fathom-consulting.com