Last week the Bank of England implied that in the event of a “disorderly” – presumably meaning a no-deal – Brexit, it is as likely to raise interest rates as to cut them. Is this plausible?
The Bank says that a no-deal Brexit could have significant effects on both demand and supply. What it should do to interest rates depends upon the balance of these effects, as well as on movements of the exchange rate.
On the supply side, disruption caused by delays at borders, dislocated supply chains and the need to make new arrangements across the whole economy, may have the effect of reducing the UK’s supply capacity, at least in the immediate short-term.
The effect of this reduction would potentially be to push up inflation. This effect would not materialise, however, if there was a margin of unused productive capacity in the economy. Yet, unlike at the time of the 2016 vote, the Monetary Policy Committee (MPC) now believes that there is no spare capacity in the economy.
Mind you, estimating the size of unused supply capacity in the economy is a dodgy enterprise at the best of times. So basing a rate rise on this reasoning would be foolhardy.
Moreover, Brexit optimists, including myself, argue that a combination of Free Trade Agreements (FTAs) and de-regulation would see an increase in UK supply capacity, at least in the long-term.
This was notably not the case with previous adverse supply shocks, such as the two oil price hikes of the Seventies or the global financial crisis, which were bound to have adverse long-term effects on supply capacity.
But even if the MPC believed that a Brexit-inspired reduction in supply capacity would increase inflationary pressures, this does not constitute a clear case for a rate rise because effects on demand must also be considered. In due course, the imposition of tariffs on UK-EU trade would have the effect of boosting aggregate demand in the UK economy, simply because we import from the EU considerably more than we export to it.
Demand would be deflected onto UK producers. Nevertheless, a no-deal Brexit might also produce a downward shock to demand as the confidence of both businesses and consumers dipped. In the short-term, I suspect that the adverse effect from lower confidence would dominate.
Over and above these influences on supply and demand, there are also potential direct effects on the price level from both exchange rate and tariff changes. A lifetime in the forecasting business has made me wary of assuming that we know how currencies are going to behave.
The current conventional wisdom is that a no-deal Brexit would cause the pound to fall sharply. If that were to happen, it would tend to raise the inflation rate, at least temporarily.
Mind you, precisely because so many people assume that this is going to happen, my suspicion is that any knee-jerk reaction against the pound would be comparatively small and perhaps quickly reversed.
Today’s circumstances are very different from 2016. The pound began that year at a much higher, uncompetitive, rate. And the referendum result was a shock.
Moreover, what happens to the exchange rate in the event of a no-deal Brexit will depend a lot on the political context. Most investors and market operators that I meet are far more worried about a Corbyn-led Labour Government than they are about a no-deal Brexit.
I think they are right to be so. Accordingly, if the final achievement of Brexit, even without a deal with the EU, brought increased support for the Conservative Government and diminished support for Labour, as well it might, then my guess is that the pound would rise.
But there is another element that has a direct impact on the price level. On leaving the EU without a deal we would impose the EU’s Common External Tariff on imports from the EU, thereby raising the UK price level.
Yet continental suppliers to the UK market would feel wary about the potential loss of market share if they put their prices up by the full amount of the tariff. Accordingly, in aggregate, they are likely to adopt an intermediate position, such that prices go up a bit but not by the full amount of the tariff.
Moreover, in due course, there would be cuts in the tariffs that we currently impose on imports from the rest of the world as we negotiate FTAs with various countries.
Given the relevant shares in our trade, these would probably just about counter-balance the impact on the price level from us imposing tariffs on imports from the EU. And there is the possibility of policy measures – unilateral tariff reductions on particular goods and/or temporary reductions in VAT – to offset the immediate impact.
In any case, on notable occasions in the past when inflation has been driven up by a major drop in the exchange rate or a supply-side shock, the Bank has tended to allow the inflation rate to exceed the target for a period. In the event of a no-deal Brexit, I cannot believe that the Bank would behave any differently.
Accordingly, if you think that a no-deal Brexit is likely and that there may be an immediate loss of confidence, then you ought to factor in the prospect of a reduction in interest rates after March.
Equally, however, if you believe that a no-deal Brexit will ultimately be perfectly manageable and, indeed, that it can bring serious advantages, as I do, then once Brexit itself has been accomplished and the initial adverse shock waves have passed through the economy, then things may quickly return to how they were before.
That is to say, the Bank should by then be extremely concerned to get interest rates back to something like a normal level as fast as is reasonably possible. It seems to me that next year interest rates could be going both down and up.
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