The BoE approach to Brexit

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The Bank is walking a fine line, taking the impact of referendum-related uncertainty into account while staying out of the political debate.

Today was the Bank of England’s second Super Thursday for this year, involving the simultaneous release of the interest rate decision, minutes of the meeting and Inflation Report. As widely expected, the BoE kept the main policy rate at a record-low 0.5% and the asset purchase program at £375 billion.

A key development was the Bank assuming that half of the recent 9% depreciation of Sterling was due to uncertainty associated with the UK referendum on EU membership in June. The assumption was based on an analysis of the relationship between movements in Sterling and news stories about the referendum. Regardless of the robustness of the Bank’s judgement, the scarcity of official comment on the potential impact of referendum-related uncertainty make it a refreshing add to the mix. Yet the BoE stopped short of forecasting how the economy would perform in the event of UK voters choosing to leave the EU.

Economic outlook a little weaker

The Bank was less upbeat about the outlook for UK GDP growth than previously and its forecasts are now roughly in line with ours. The economy is now expected to grow 2% this year, compared to our forecast of 1.9%. Similarly, the BoE now sees growth of 2.3% in 2017, still below our forecast of 2.2%. The forecasts assume that the UK remains in the EU and any slowdown flowing from uncertainty about the referendum will be made up in subsequent quarters. Such an assumption is reasonable because experience has shown pent-up demand has been satisfied when other periods of uncertainty have been resolved.

A key factor behind the downgrades was a weaker outlook for productivity growth, which seems fair as recent official data continues to show that the UK’s productivity performance remains weak. Another was that the BoE is less optimistic than previously about how willing households will be to dip into savings to fund current consumption. Given that economic growth slowed in the three months to March and that surveys suggest it will continue to do so in the current quarter, and that job growth is slowing and inflation is likely to gradually rise, this appears reasonable.

BoEGDP 

Investment forecast for 2016 slashed

The forecast for business investment in 2016 was revised down sharply to 2.5%, with the Bank citing weakness in investment by extractive industries. Such a move is warranted because our Manufacturing Outlook survey has in recent quarters shown that the collapse in the oil price has weighed heavily on the demand of oil and gas companies in the North Sea and abroad for investment goods. Yet the Bank’s forecasts for business investment after 2016 look too strong. The BoE upgraded its forecasts to 7.25% and 7.35% in 2017 and 2018, respectively. While our most recent Outlook survey suggested that the drag on sectors embedded in the oil and gas supply chain may be bottoming out, the impact of the low oil price is likely to linger.

BoEInvestment 

Inflation outlook little changed

On the inflation front, there were some small revisions to the forecasts for this year and next.  Yet the forecast for late 2018 which is the most important as the Bank targets inflation in the medium term (that is, in one to two years’ time), remained at 2.2%. This, along with today’s Inflation Report marking the fourth in a row in which inflation in late 2018 has exceeded the BoE’s 2% target, indicates that there is no additional pressure on the Bank to start raising interest rates.

The inflation forecasts suggest that official interest rates are unlikely to start to rise anytime soon. At the same time, the recent signs that the UK economy is coming off the boil are not enough to warrant a rate cut.

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