Pre-exit, Brexit, what was it? Why the BoE should delay a change in monetary policy.

Post the Brexit referendum we are in an economic purgatory. The brexiteers are looking forward to a democratic led revitalisation of the economy, while the bremainers fear that the “little England” mentality will leave us isolated and depressed. Most people have an opinion, and the economic opinion that matters the most is that of the Bank of England (BoE). The market has absorbed the news of Brexit and adjusted: sterling down, foreign earning equities up, and UK government bond yields down to record lows.

The BoE now has the opportunity to publish its thoughts this Thursday on Brexit in its Inflation Report. The market is assuming that the Bank of England now has to act to prevent the severe crisis risk it outlined in previous press conferences. However as the UK is currently around two and a half years from departing the European community, the BoE has time on its side: half a year of pondering the implications of Brexit, and then two years of full membership to consider post-Brexit.

The first thing the BoE will consider on Thursday is where the UK economy was before the referendum. The answer is the economy had low unemployment, strong real wage growth, and a consumer boom as typified by the record trade deficit. Looking forward, the new government is likely to implement fiscal stimulus, the BoE may ease monetary policy through a combination of lower interest rates and unconventional methods, and the fall in sterling will provide an economic tailwind. In layman’s terms, we have a healthy economy, operating at near full capacity, that is about to be given a shot in the arm from a fiscal, monetary, and exchange rate perspective. On the negative side, the UK economy is going to experience some potential slowdown in two and a half years’ time, as barriers to trade with our neighbours are likely to be implemented. With some associated falls in potential capital expenditure and consumer confidence before this.

The tailwinds look capable of more than matching the headwinds over the next two years. Indeed, if you are a business and have any spare capacity that needs to be used ahead of the Brexit deadline (for example a UK based car manufacturer), the logic should be to produce at full speed before the trade barriers are increased, especially given the fall in sterling. It looks like UK exporters are in a great position until the spring of 2019.

The BoE’s own forecasts pre-Brexit show inflation returning to or above target over the next couple of years. The problem the BoE now faces is that the benefits of Brexit (looser fiscal policy, looser monetary policy, and the lower exchange rate) will occur well before the potential headwinds in 2019. The monetary authorities like to work in a counter cyclical fashion, however the economic damage that could occur from the decision to leave could well be delayed. In fact acting aggressively early could well result in a mini boom, which will make the eventual delayed event of Brexit appear even more severe. For these reasons, the BoE should not be too aggressive in easing monetary policy on Thursday.

The chances of a recession and deflation in 2019 will depend on how the UK economy adjusts to its new role in the world. Or just maybe, in two and a half years’ time market mechanisms such as the exchange rate and the fact the UK has had time to prepare for leaving the EU will mean the market will be focused on new issues and not an event that could seem like a distant memory.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Discuss Article

  1. Vaibhav says:

    I have a question – its been 6 weeks (approx.) since brexit – considering the process doesn’t begin until 2 year after triggering Article 50 (which we have no clue when it will be triggered), why is the market reacting so adversely and why should the BOE lower interest rates and try to stimulate the market. Nothing has fundamentally changed since June 22. Shouldn’t the market wait until, we actually trigger Article 50 and then let the apocalypse begin. I cant get my head around this premature reaction to an event that may or may not happen.

    Posted on: 09/08/16 | 11:16 am

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