The UK economy is likely to lose momentum in the coming months. A recession is not inevitable but it is certainly a distinct possibility. In the short run the major concern is the shock to ‘animal spirits’, for want of a better phrase. Households and companies will become more pessimistic about their future prospects, causing consumption and investment to slow.
Moreover, uncertainty about the future—and in particular fear that the economy will take a sharp turn for the worse—will increase, and that shift in perceptions could further weigh on spending. Precautionary savings will likely increase, with households building up a buffer of liquid assets as an insurance against potential shocks to their disposable income. Spending on durable goods looks particularly vulnerable. Likewise the hurdle rate on investment is likely to increase significantly: any capital expenditure that can be delayed in the short run probably will be delayed until companies have a clearer picture of the outlook.
These effects are likely to be particularly pronounced in the case of companies considering inward investments into the UK or UK companies who export a significant fraction of their output to the European Union.
On the other side of the ledger, the sharp fall in the value of the pound (see exhibit 1 below) should help cushion the blow on demand.
Exhibit 1: The pound has fallen sharply against the US dollar since the vote, on 23 June 2016, in favour of the UK leaving the European Union.
Source: Bloomberg, BNPP IP as of 29/07/16
UK households and companies should substitute away from more expensive imports and their counterparts abroad should substitute towards cheaper UK exports. However, past experience suggests that the boost from ‘net trade’ may take some time to materialise, with the possible exception of the tourist trade. UK households may find it difficult to substitute away from more expensive imports if there are few domestically produced alternatives. UK companies may not cut their prices in foreign prices in an effort to sell more output and may instead take the depreciation in the currency as a windfall gain on profit margins. Indeed, UK companies may find it particularly difficult to increase market share in global markets by attracting new customers given the uncertainty around our future trading arrangements.
In the longer run, the economic implications of Brexit hinge on the end game of the negotiations. If we end up in the ‘out, out’ scenario then it seems probable that the erection of barriers to trade with the UK’s major partners in Europe will have a persistent and material impact on trade flows with Europe (with no clear reason to suppose that trade barriers with the rest of the world will fall) and that that in turn will discourage foreign direct investment (FDI) into the UK. Economics suggests that both of these factors are consistent with a permanent hit to UK GDP.
International trade is thought to encourage a more efficient allocation of labour and capital within countries (as we each concentrate on what we are good at producing) and over and above contributing to the capital stock FDI is thought to facilitate the adoption of new technologies and ideas. Finally, a lower net migrant inflow also implies lower growth in the working age population and hence the economic capacity of the UK economy.
The domestic policy response
A shock on the scale of Brexit demands a policy response. The Bank of England has already responded. The Bank stands ready to provide liquidity to the UK banks should they need to use it. The Financial Policy Committee has temporarily cut capital requirements for the UK banks to try to minimise any reduction in the supply of credit to households and companies. The Governor has signalled that the Monetary Policy Committee (MPC) stands ready to provide monetary stimulus in the coming months.
Looking ahead, bank rate is likely to be cut close to zero, and in the worst case scenario perhaps even below. The MPC also has the option of restarting its Quantitative Easing programme, through which the Bank prints money to buy government bonds (and potentially corporate bonds too), or extending its Funding for Lending programme, through which banks are incentivised to lend more to UK households and companies via cheap long-term funding. In practice, the Bank is likely to do a combination of these things, and a package of measures will probably be announced at the August 2016 meeting. How much the Bank ultimately does will hinge on two factors: how big the Brexit hit to activity is and how far inflation climbs above the target thanks to the sharp depreciation of the pound.
At the current juncture the Bank seems set on erring on the side of doing ‘too much’: the Bank’s Chief Economist recently spoke of preferring to use a sledgehammer to crack a nut than a miniature hammer to tunnel his way out of prison – although it should be noted that he voted to leave interest rates on hold in July. In any case, it is important to keep in mind that monetary policy can only mitigate some of the cyclical pain that is likely to be felt along the transition to the new steady state to which the UK economy is heading. The Bank can do little to address the structural damage done by Brexit.
There will probably be a fiscal response too. Brexit is likely to lead to a cyclical deterioration in the public finances and a structural deterioration too in the event of the ‘out, out’ option. In theory, that bad news will require more austerity, not less if the current fiscal rules are to be respected. However, it seems likely that the Government will not aim to achieve a surplus in 2019-20. Further consolidation may be delayed, and fresh stimulus may even be injected. Investors are going to have to digest a lot more issuance of gilts. The people may have spoken but the macroeconomic consequences are only starting to sink in. In the short run the increase in uncertainty will weigh on demand and may well drive the economy into recession, but it is the nature of UK’s final settlement with the EU that will determine the impact of Brexit in the long run.
The Bank of England will do what it can to cushion the blow but it can do little to offset the structural damage to the economy and that will hinge above all else on the extent to which Brexit leads to the erection of trade barriers with the UK’s major trading partners. [divider] [/divider]
This article was written by Richard Barwell, senior economist, on 1 July 2016 in London