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Open Europe's Jayson Probin and Raoul Ruparel investigate how the Bank of England might respond to the short term shock of a Brexit vote. Such an outcome would likely leave the Bank of England stuck between a rock and a hard place - disinflationary pressure from an economic shock and inflationary pressures from a devaluation of the pound.
There is a broad consensus that the immediate aftermath of a Leave vote in the EU referendum would trigger a short term period of uncertainty – both political and economic. While this is likely to dissipate to some extent in the longer term – though the exact extent is a big topic of discussion (see here and here for our long term view of Brexit) – there would be significant pressure on the Bank of England (BoE) to act to try to mitigate some of the short run economic uncertainty and volatility. However, the nature of the impacts could put the BoE between a rock and a hard place.
The two main impacts which would concern the BoE would be:
The particular focus would be how these impacts might feed through to inflation, the BoE’s main concern.
The Bank of England yesterday warned that leaving the EU could “materially alter the outlook for inflation and output” and could even tip the UK into a “technical recession”. While some have attributed this to ‘project fear’ there are other indicators which suggest that uncertainty over Brexit is weighing on the economy – a factor which could become exacerbated post Brexit until the longer term picture becomes clear.
Recent PMI data has suggested that the uncertainty is weighing on services, manufacturing and construction – though of course other factors are also in play. But a recent slowdown in commercial property transactions as well as IPOs and private equity investments, suggest a similar story. In the aftermath of Brexit there would be some uncertainty over where the UK is going – who will be in charge, what relationship we will seek with the EU, what our domestic approach to regulation and immigration might be and how we will approach trade with the rest of the world to name but a few. As such, it’s not hard to imagine these unknowns weighing on business investment and decision making until the picture becomes clearer.
This could all constitute a short term shock to the economy and also put further downward pressure on inflation. (Of course, the decision over whether to Remain or Leave should in our view be taken on the longer term bigger picture issues).
We’ve already seen a sharp decline in the value of sterling – with the effective exchange rate index has declined by 9% since November 2015.
There are three basic channels through which the devaluation might materialise:
Most market players predict the pound would fall further in the event of Brexit – although the specifics of such predictions should be taken with a large pinch of salt given that this is an unprecedented event. Nevertheless net shorts on the Pound remain near record highs (see chart below), suggesting investors are positioning for a potential further weakening.
The estimates of how much sterling would depreciate vary from 10% (AXA Investment Managers, Bloomberg) to 20% (Goldman Sachs, Citi Group) – though it is unclear whether these come on top of the 9% decline already seen since November.
It is incredibly tough to estimate with any real precision how the short term economic shock and sterling devaluation might feed through to inflation, particularly given the host of other factors at play. However, we can clearly say they are likely to be pushing in opposite directions.
The short term economic shock, particularly if it manifests as a standard shock to consumer demand, would likely put further downward pressure on inflation. Though the exact impact on prices may well depend on how prolonged the shock is or is seen to be.
On the other hand, devaluation is likely to lead to upward pressure on inflation. We can also examine a bit more the extent of this pressure. The BoE has itself put the pass through rate of exchange rate devaluation to the price level at between 10% and 31%. Combining this with the likely devaluation range of between 10% and 20%, we can sketch out a very rough range of the impact on inflation. Based on these figures, the likely level of sterling devaluation could lead to an increase in inflation of between 0.5% and 3% – a wide and uncertain range. Furthermore, it is hard to say how long this sort of impact would take to feed through – for example a recent speech by a member of the BoE’s Monetary Policy Committee said that it can take between two and five years for movements in the exchange rate to fully feed through into the price level. It is also unclear whether the devaluation would be short with a rebound fairly quickly or whether it would be a prolonged weakening of the pound. It should also be considered that, according to a recent East&Partners survey, listed firms have hedged 83% of the currency risk around the referendum – so may well be prepared for any devaluation and partly internalised the cost already.
Firstly, it must be kept in mind that BoE policy is first and foremost designed around achieving its 2% inflation target. Indeed, the Bank itself said in the minutes of its April Monetary Policy meeting that in the event of Brexit “monetary policy would be set in order to meet the inflation target”. That said, the BoE has in the past shown some flexibility, particularly when it comes to the upside of inflation, to help support growth.
This flexibility could well be needed given that it seems likely the economic uncertainty and devaluation will put opposing pressures on inflation, putting the BoE in a tough spot as to how to respond.
The likely response to economic uncertainty and a short term demand shock would be for the BoE to keep monetary policy loose or even to ease further if necessary. This could manifest itself in a number of ways such as keeping interest rates lower for longer, considering reactivating bond purchases or moving into negative rates as some other central banks have done (as well as many other options). The BoE has already offered up further liquidity operations around the referendum to help ensure sufficient cash on hand for the financial system.
However, such action could be constrained by the devaluation and the potential ensuing inflation impact. The traditional response to a weakening currency (especially due to declines in inflows) would be to raise rates to try to make investments more attractive. As such, the BoE is unlikely to want to ease heavily into a weakening currency.
How these two competing pressures will balance out is unclear – hence so is the BoE’s response. If the devaluation and inflation effect dominates the disinflation from a negative shock, then the BoE will unlikely feel able to ease policy significantly and may even feel tempted to raise rates to combat potential inflation.
As the Bank of England said yesterday,
The MPC would face a trade-off between stabilising inflation on the one hand and output and employment on the other. The implications for the direction of monetary policy will depend on the relative magnitudes of the demand, supply and exchange rate effects. Whatever the outcome of the referendum and its consequences, the MPC will take whatever action is needed to ensure that inflation expectations remain well anchored and inflation returns to the target over the appropriate horizon.
One thing that is also clear is that facing up to such conflicting challenges is unlikely to be possible using interest rates alone – they are too blunt a tool for such diametrically opposed pressures. One alternative way the Bank could respond would be to try and attempt to prevent the devaluation through direct intervention in the currency markets using its foreign exchange reserves (although at a large scale this would need to be initiated by the Treasury). Between them the BoE and the Government have $163bn in official reserves ($115bn in foreign exchange reserves). Indeed, the Bank has reportedly been increasing its foreign exchange reserves recently – suggesting this is an option that the Bank is considering. That said, the level of reserves still pales in comparison to the size of the sterling foreign exchange market and suggests the Bank could struggle to prop up the pound.
While this may all seem very niche, it does have wider implications both in terms of people’s day to day lives and in terms of the bigger picture of the UK economy.
Firstly, a sharp devaluation and a potential spike in inflation could leave people feeling worse off (particularly since they will be able to relatively import less and spend less abroad), particularly if combined with a loss of income from a negative economic shock. The extent of the devaluation and potential inflation will be important and therefore so will the response of the BoE. Secondly, what happens to rates and BoE policy more broadly will help to manage how Brexit uncertainty feeds through to the economy. This impacts all manner of things from prices to employment. It will specifically have a big impact on the cost of borrowing and particularly the mortgage market – and therefore also the housing market.
In terms of the bigger picture, this is important as the UK is currently running a very large (at times record high) current account deficit and large budget deficit. The current account deficit – which stood at a record breaking £32.7bn or 7% of GDP in the last quarter of 2015 – which means the UK is reliant on capital inflows from foreign investors. These inflows could be at risk and the larger the gap becomes the bigger the likely devaluation and therefore sharper the adjustment for the economy (particularly in terms of imports if this becomes a lasting issue). Of course, devaluation could in theory help make UK exports more competitive and may help close the current account deficit. The evidence on this is mixed, since a large devaluation following the financial crisis (over 20% against the US Dollar) failed to provide any material boost to UK exports. The BoE has also said it does not believe the boost to trade would offset other potential impacts of the devaluation. Furthermore, because the UK is also running a large budget deficit (forecast to be 3.8% of GDP this fiscal year), meaning it has twin deficits, and the UK’s Gross external financing need is by far the largest in the developed world at almost 800% of foreign currency reserves and current account receipts (according to S&P) it is potentially vulnerable to a shock.
Of course, all this should not be overdone. The short term impacts will likely dissipate and how they might feed through to long term impacts remains unclear. Ultimately, the BoE’s response will be about helping manage the transition and smooth out any volatility/uncertainty. The more important question about the long term health of the UK economy will likely be decided by supply-side policies. Despite the BoE weighing in on this issue yesterday, these will be determined by the government. More specifically, as we spelt out in a recent paper, it will be determined by the UK’s approach to issues such as trade, immigration, regulation and competiveness. There are gains to be had from Brexit in these areas but they don’t come easily and will take time to materialise. Which will feed back into pressure for short term action from the BoE – the question is how it will manage the forces potentially pulling it in opposite directions.
(Open Europe research intern Jayson Probin also co-authored this blog).