28th June 2016
James McCann, UK/Europe economist Standard Life Investments discusses the implications of the Brexit vote.
The most searched question on google since the EU referendum result has been: what does it mean to leave the EU? Markets are asking themselves the same question, judging from the price action after the announcement. A vote to leave constitutes an economic shock. Indeed, we have experienced a foreshadowing of these effects over recent months, with growth slowing markedly as firms delay investment and hiring. The main channel for this shock is a huge increase in uncertainty. 45% of UK trade is carried out with EU member states and 7% of UK employees are EU nationals. Moreover, the UK financial sector is heavily integrated with the rest of Europe, as are a huge range of professional services. With no clear template for a post-exit relationship with the EU, businesses with ties to the continent have been left in limbo for at least two years during negotiations, but more likely longer.
We expect the impact of this shock to be pronounced. Investment and hiring plans for those companies sensitive to EU trade are likely be shelved, which will rapidly pass through to connected sectors of the economy. Consumer sentiment is expected to take a smaller hit in the first instance, although this is likely to increase as the shock feeds through to the labour market. We have already seen an increase in financial stress, and credit conditions are likely to tighten. Calibrating these effects is difficult. However, we expect a marked impact on growth and see a strong possibility that the economy moves into recession. This will be disinflationary for the domestic economy, although this will not show up in the data immediately. Instead the sharp adjustment seen in sterling will push inflation artificially higher as import prices rise. However, beneath the surface this shock will open up more spare capacity, even taking into account a weaker potential growth rate after exit.
The Bank of England’s (BoE) first response has been to offer liquidity support for the financial sector. It has not yet loosened monetary policy, although this can’t be far off. The shock to the economy justifies easier policy and the BoE is unlikely to be deterred by a short-term pickup in inflation as sterling depreciates. Indeed, it looked through a similar inflationary bump after the financial crisis (see Chart 4). We expect the Bank to cut rates at its upcoming meeting in July. However, the scope to loosen through this channel is limited and the BoE has already flagged its reluctance to use negative interest rates given the impact these have on the financial sector. Therefore, the MPC is likely to restart quantitative easing to provide further stimulus, potentially as soon as August. There is a caveat here. The Bank will only be able to loosen if the depreciation in sterling is orderly. The UK is running a large current account deficit and if we see a more abrupt freeze in external financing then the BoE may have to take steps to support the currency, potentially by increasing interest rates (see Chart 5). This is not our base case, but it cannot be ruled out. Finally, we also expect fiscal policy to loosen over coming months. In the first instance, this will come through automatic stabilisers and a less rigid adherence to budget targets. However, we expect a new Conservative leadership to unveil a more explicit stimulus programme in a bid to try and soften the impact of Brexit.
James McCann, UK/Europe Economist