Suppose the UK had voted to stay in the EU. Would the Bank of England have hiked its benchmark interest rate by now? Yes, probably. But that didn’t happen. Instead, the central bank aggressively expanded monetary policy in August, shortly after the UK voted for Brexit. The Bank's efforts, in conjunction with Theresa May’s ship-steadying politics, helped to avert an economic crisis immediately after the vote.
The most remarkable thing to happen since 24 June is that UK households and firms have barely, if at all, responded to the uncertainty about the UK’s future relationship with its biggest market, the EU. Households have continued to spend at a solid pace and businesses have not cut investment. The UK economy continued to expand at its potential rate during the second half of 2016.
Things may change in 2017. With Theresa May set to give a speech today pointing to a hard(ish) Brexit, businesses will likely hesitate a little more when making investment decisions, especially those with long-lived implications. Meanwhile, slowing employment gains in a labour market which has reached full employment, and downside risks to real wage growth from the sterling-related rise in inflation, will act as drags on household consumption growth.
While the economy will probably continue to modestly outperform consensus expectations for GDP growth over the medium term, the notable easing of momentum and heightened Brexit uncertainty will likely keep the Bank on hold for the foreseeable future, despite the above-target rise in inflation which is set to begin in mid-2017.
But critically, risks to growth are skewed a little to the upside, meaning that the Bank is likely to favour tighter rather than looser monetary policy before the end of this year, if any policy change should occur.
Why? First, households and firms started to gear up again in 2016, having reduced debt relative to income and strengthened their balance sheets since the financial crisis. Most notably, household credit growth reached a decade high. If households borrow a little more this year than they did last year, and continue to draw down on savings, the current strong growth rate of household consumption could easily be sustained.
Second, medium-term expectations for investment are weak, following sluggish growth in business investment during the post-Lehman expansion.
With little slack in the economy, continued strong demand growth coupled with weak supply growth, inflation would likely overshoot the Bank’s 2 per cent target rate by more – and for longer – than the dovish Monetary Policy Committee would like to tolerate. In such a scenario the Bank could begin to tilt from its current neutral stance to a more hawkish one. A first rate hike in late 2017 could be one of the surprises of the year. Watch this space.