In presenting the latest Bank of England quarterly Inflation Report, Governor Mark Carney has warned that a vote to leave the EU in the upcoming referendum “…could lead to a materially lower path of growth and a notably higher path of inflation than in the central projection…”, which is largely in line with our analysis of the risk of Brexit…..
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Azad Zangana, Senior European Economist & Strategist
The governor said aggregate demand would likely fall in the face of tighter monetary conditions, lower asset prices and greater uncertainty about the UK’s trading relationship.
Meanwhile, the Bank expects households to defer consumption and companies to delay investment. In addition, the Bank warns of global spillover effects which could in turn hurt overseas demand for UK exports.
When pressed, Carney admitted that a vote to leave “could possibly include a technical recession” – the strongest statement yet from the Governor who considers Brexit to be the biggest domestic risk to the Bank’s forecast.
On the supply side of the economy, Carney said that slower capital accumulation and the need to reallocate resources across the economy in response to changes in trading and investment could limit supply and cause inflation to rise.
The Bank also warned of the inflationary impact from a substantial fall in sterling, which could persist for years.
On interest rates, Carney argued that the direction of monetary policy in a Brexit scenario could go in either direction. The central bank would face a trade-off between lower growth and therefore lower inflationary pressures over the medium-term with higher inflation from sterling and tighter supply in the economy.
While Carney’s conclusion can be justified by the economic arguments presented, it seems that his diplomatic answer is designed to avoid a political backlash from either side of the Brexit contest.
Rate cut most likely?
In our view, the Bank of England is likely to cut interest rates in order to minimise the impact of Brexit on demand, and will probably seek to lower inflation at a later point.
This is consistent with its policy response since 2010 where inflation has been allowed to run much higher than its target in order to support demand. We should add that Carney also warned that monetary policy may not be enough to support demand in a Brexit scenario.
Although additional sterling liquidity is to be made available just before and after the referendum, he warned that monetary policy has its limits, hinting that fiscal stimulus might be required.
As for the inflation report itself (which the press conference largely ignored), the Bank has downgraded its growth forecast and raised its inflation forecast for this year and next.
UK slowdown difficult to gauge ahead of Brexit vote
The economy is clearly slowing, possibly due to the uncertainty caused by the Brexit debate, but potentially due to other reasons.
The Bank took a cautious approach in examining the data as, if the slowdown is due to Brexit fears, then we should see a recovery in activity in the months that follow the referendum (assuming a vote to remain).
However, it is difficult to accurately apportion the scale of the slowdown to Brexit fears, and if there are other factors causing the slowdown, then the Bank may need to keep the status quo for longer, or even loosen policy further.
We note, however, that if the UK votes to remain, the Bank’s inflation forecast suggests interest rates will rise faster than currently assumed by markets (first hike in 2019).
We agree with the analysis which is why we continue to forecast the Bank will start to raise interest rates at the end of this year.