Easy does it for the MPC

The precipitous fall in sterling since 23 June, which has seen only the Mozambique New Metical and the Sierra Leone Leone perform worse, was a predictable response to the referendum outcome to leave the EU. Countries that pursue policies that are damaging to their growth prospects can expect to see their currencies adjust downwards to reflect the lowered attractiveness of that economy to investors. And the fact that the recent leg down in sterling came on the back of announcements from the Government suggesting that it favours a “hard” Brexit including departure from the Single Market, strengthens the evidence that sterling’s fall is being primarily driven by the economy’s much-diminished economic prospects.

The fall in sterling inevitably makes Britons poorer, not least as import prices rise in response. There is little evidence that has had any meaningful impact on consumers yet – the rise in inflation reported earlier in the week to 1%, a two-year high but still only half of the BoE’s target rate, was more about the impact of past energy prices dropping out of the numbers. But as firms’ currency hedges roll off over coming months the impact on inflation of the drop in sterling will be profound – we expect headline inflation to hit 3% or more by the end of next year.

In response to the worsening in the inflation outlook, Gilts have also sold off over the past couple of weeks, taking the 10Y yield from 67bps at the end of September back to 1.12% currently. At the same time, markets have further priced out the possibility of a further rate reduction from the BoE, and the probability of a rate cut by the time of the Bank’s February meeting implied by swaps prices is now barely more than 10%. In fact, some commentators have begun to suggest that, faced with a lower pound, higher inflation and rising inflation expectations, the BoE could be forced into the sort of interest rate hikes that emerging market central banks regularly have to implement to restore confidence in their currencies and policy frameworks.

That seems far-fetched. While the prospect of Brexit, and the associated deterioration in the quality of Government economic policy-making, has certainly dented confidence in the UK’s institutional framework, it is not (yet) at emerging market standards. And, neither, does higher inflation automatically imply the need for tighter monetary policy.
For sure, a period of above-target inflation complicates the MPC’s job – having spent several quarters writing letters to the Chancellor explaining why inflation has been so far below target, before long Mark Carney will have to start writing letters explaining why it is so far above target. But Carney’s discomfort will not determine policy – the economic outlook will.

BoE easing periods and key indicators*20Oct16Shaded areas represent periods when policy was being eased. Source: Bloomberg, Thomson Reuters, BoE and Daiwa Capital Markets Europe Ltd.

One guide to how the MPC will react to the coming period of higher inflation is to look back at the post-crisis period (see charts). Twice the MPC was very happy to ease policy aggressively (shaded areas represent easing periods) even as inflation hit 5% and (in the 2008/09 period at least) inflation expectations were elevated. And easing continued even as uncertainty (as measured by the VIX) declined. Key to these easing decisions was the MPC’s view of the economic outlook and, in particular, the behaviour of wages.

In terms of the economy, the medium-term outlook is arguably as uncertain as at any time since the dark days of 2008. While the economy likely grew by about 0.4%Q/Q in Q3, the subsequent realisation that a hard Brexit is the most likely outcome is putting further downward pressure on growth, not least as firms, and foreign-owned ones in particular, reassess their investment plans. And with a triggering of Article 50 in March next year pointing towards the UK leaving the EU in early 2019, the likelihood that it will leave with no trade deals with the EU (or possibly anyone else) in place, will result in a huge negative economic shock as firms face tariff and non-tariff barriers on their exports and imports become subject to tariffs. This shock (a shock that will become increasingly apparent as the leave date approaches) will ensure a sharp retrenchment in economic activity and higher unemployment.

And higher unemployment will ensure that higher inflation does not feed through into higher wages – the BoE will therefore feel no need to tighten. Indeed, if as in the two most recent periods of easing, it merely serves to depress real wage growth, putting downward pressure on household expenditure, higher near-term inflation is actually an additional reason for the MPC to loosen policy further. As for market expectations of inflation, the MPC will ignore those, even if they spike – what’s happening to wages will be front and centre to its decision making.

So, we continue to expect further easing from the MPC, most likely at its February meeting, via a cut in Bank Rate and additional Gilt purchases. And that is even on the back of our expectation of a further fall in sterling as the triggering of Article 50 gets ever closer, which will put further upward pressure on inflation. But whatever the Bank does, it will not be able to fully offset the negative shock to the economy of hard Brexit, which will leave the UK perpetually poorer than it otherwise would have been. Indeed, knowing the storm that is coming, and given the recent political briefings against him, whether Mark Carney will want to hang around for much longer is uncertain. If he does indeed decide later this year that he would prefer to move on in 2018 as was his original intention, expect markets to react with horror as one of the few grown-ups left in UK economic policymaking departs the scene.

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