More questions than answers
25 July 2017
There has been no shortage of questions around the UK outlook since the vote to leave the EU. The one which has been perplexing economists most remains unanswered; how will exit affect the economy over the short term? Certainly the initial fall- out was mild, with growth underpinned by undeterred consumers. However, there is evidence that activity is now wavering, as rising inflation puts pressure on households (see Chart 3). Growth slowed materially in Q1 to 0.9% annualised, with weaker consumption partly to blame. Is this a blip? Growth data for Q2 released later this week will complete the story for the first half of the year. Data have been mixed, with retail sales posting a weather supported rebound, while other items of consumer spending, such as car sales, have been soft. Meanwhile, industrial production, construction and trade data have all been weak. Another quarter of below-trend growth would provide further evidence of faltering activity. However, we will have to wait until the second half of the year to get the full picture. Our expectations are for consumer spending to remain weak due to pressure on real incomes (despite a tightening labour market). This is expected to weigh on growth, with few signs that better activity in the export and production sectors will provide sufficient compensation.
The next natural question relates to the monetary policy outlook. How will an increasingly fractured Bank of England (BoE) steer policy through the rest of the year (see Chart 4). This will of course be influenced by how the issues above pan out. However, more difficult to predict is the extent to which the Bank’s reaction function might have changed. In the wake of the referendum the Bank eased policy proactively and left loose policy settings in place even when the economy performed better than feared. This seemed to reflect a ‘dovish’ tilt on the Monetary Policy Committee (MPC), with risks around the outlook judged to be firmly to the downside. However, is this cautious bias still in place? More ‘hawkish’ elements have already called for a withdrawal of last year’s rate cut and Chief Economist Haldane has flagged that the balance of risks around policy have shifted. Certainly if growth does not slow as we expect then rate hikes look likely sooner rather than later. If our forecast slowdown materialises, the response is not completely clear cut. On balance we expect weaker activity to justify unchanged interest rates, particularly given the already considerable pressure on households. However, this may still be contentious for the MPC, especially if slower growth does not lead to a deterioration in the labour market.
The final point of interest through the rest of the year relates to Brexit negotiations. There are three key issues which need to be agreed upon before any discussion around what the future relationship between the UK and EU might look like; the size of the UK’s exit bill based on existing commitments; the rights of EU citizens living in the UK (and vice versa); and the Irish border. The degree of progress towards these issues will provide some useful signposts as to how constructive and easy future negotiations may prove. If agreement on these first steps is slow and painful this will exacerbate fears that the UK might be headed for a more acrimonious split with Europe, which would have deeper economic and market consequences.