Central Banking After Brexit

With Brexit all but confirmed, after over three years of waiting and two general elections, the U.K. is poised to face a new set of economic challenges in 2020 and beyond. At this turning point, The Bank of England is also preparing to bid adieu to its current governor, Mark Carney, whose tenure was dominated by Brexit concerns. In his place, the central bank will welcome Andrew Bailey, the CEO of the U.K.’s Financial Conduct Authority, as its new chief. As a new year greets us, we must look ahead at the likely fate of the U.K.’s economy and whether the Bank of England’s monetary policy toolkit is prepared for what lies ahead.

There are two key dates to keep in mind. First, Jan. 31, 2020 acts as the deadline for the U.K. to officially leave the European Union, as per the extension granted by the European Council in Oct. 2019. Second is the Dec. 2020 deadline, which marks the end of the post-Brexit transition period. This date could mark the fabled “cliff edge,” a period defined by a sudden absence of a trade deal with the EU, that the U.K. economy would plunge off of if no trade agreement is reached. Despite prime minister Boris Johnson’s insistence that a deal can be reached in time, history points to the fact that this is unlikely as free trade negotiations generally take at least a few years to conclude before they can begin to be implemented. EU ambassadors have voiced concern about Johnson’s timetable, with many sceptical on its feasibility. European Commission president, Ursula von der Leyen, has also expressed worry. Given that the transition period ends in Dec. 2020, it is likely that while this year will be relatively free of any major Brexit-related shocks, 2021 could bring the sudden consequences of a no-trade-deal Brexit. Either that or another hypothetical extension to the transition period could be administered, though Johnson has categorically ruled this out. And so, it is quite possible that the U.K. is set to go into 2021 without a trade deal with the EU.

What Lies Beyond the Cliff Edge?

 The key figures to watch in the event of no-trade-deal — and in general for monetary policy purposes — are unemployment, GDP and inflation. Governor Mark Carney said earlier this year that U.K. GDP could shrink by 5.5% in the event of no-trade-deal. This was less damning than an earlier scenario that put the figure close to 8% (though this was in the event of no transition at all), but worrying nonetheless. Inflation (CPI) is predicted to surge between an eyebrow-raising 4.25% to 6.5% from its current 1.5%, according to a Nov. 2018 report by the Bank of England. This is a major spike and exceeds the latest peaks at 5.2% in Sept. 2008 and Sept. 2011. Unemployment fares no better, with estimates of post-no-deal figures at around 7%, according to the same 2018 piece. In contrast, the latest data point lies at 3.8% for Aug.-Oct. 2019.

It doesn’t take an economist to infer that no-trade-deal would have incredibly adverse impacts on the U.K.’s economy. If the U.K. failed to negotiate a free trade deal with the EU it would return to trading on WTO terms, on a “schedule of concessions.” Tariffs and quotas would be set at a fixed rate among goods and services for all of the U.K.’s trading partners, including the EU. Additionally, U.K. exporters would be faced with tariffs on their exports into the EU and other economies, which would lower their profits as foreign consumers shift to cheaper alternatives.

Tariffs would also cause inflation which would raise living costs. If tariffs are implemented on new goods, prices will rise for consumers, leading to inflation. However, it should be noted that the U.K.’s proposed schedule of concessions puts a tariff of 0% on 87% of imports, up from the current figure of 80%. According to this proposal, tariffs would be maintained on goods competing with certain domestic industries such as meat production and automobile manufacturing to protect them while loosening tariffs on household goods like oranges to avoid raising living costs. Then what accounts for the forecasted rise in inflation, if not purely tariffs? The sheer uncertainty caused by no-trade-deal would drastically lower demand for British Pound Sterling, causing it to depreciate, which has a “large and protracted pass-through to consumer prices,” resulting in inflation. Hits to unemployment and growth would be a direct result of falling demand for U.K. exports.

 How Will the Bank of England React?

 The Bank of England’s toolkit is constrained. Its main policy tool, the Bank Rate — the rate at which financial institutions can borrow from the Bank of England and which determines broader interest rates in the economy — lies at 0.75%. It has been maintained at this level since Aug. 2019. Ever since 2008/9, the Bank Rate has been historically very low as the Bank of England cut it drastically between Sept. 2008 to Mar. 2009, from 5% to 0.5% to provide stimulus during the Great Recession. It has remained below 1% since.

 A concern for policymakers is the limited ability to cut the Bank Rate any further, which would be needed to deal with the potential recessionary impacts of Brexit. This would work by stimulating spending in the economy by making borrowing cheaper. Monetary Policy Committee (MPC) member Gertjan Vlieghe has expressed that a no-deal scenario could mean record-low interest rates. He has also stated that interest rates could potentially go negative, though Mark Carney has rejected this.

 A delicate balancing act is to be struck between cutting rates to avoid damage during a recession and the potential for skyrocketing inflation brought on by excessive borrowing. A no-trade-deal Brexit seems to bring a stagflation-like scenario where growth is negative or low, inflation is high and unemployment is rising. In this case, a rate increase could be argued for to curb inflationary pressures. However, it seems most sensible that in the event of intensely slowed growth and high unemployment, the Bank of England would do its best to prevent these twin perils by cutting rates. In correspondence with the DPT, former MPC voting member, professor David Blanchflower of the department of economics stated that it “seems inevitable [that] rate cuts will come.”

 In addition to adjusting the Bank Rate, the Bank of England may consider continuing quantitative easing (QE) in order to stimulate the economy by lowering borrowing costs for businesses and households. The most recent round of QE was in Aug. 2016. QE would be an alternative to the stimulus that negative interest rates would provide. Commenting on these options, Blanchflower said that he doesn’t necessarily see a trade-off between QE and negative interest rates and believes that both “more [quantitative easing] and negative rates look inevitable” and that “it would be foolish to rule [negative rates] out.”

 However, it may be argued that the Bank of England is not necessarily the most important entity in dealing with the fallout from Brexit. According to the Bank of England itself, “There is little that monetary policy can do to offset supply shocks.” Yes, the central bank has a duty and unique ability to influence larger economic trends in the U.K., but monetary policy’s impacts are never immediate and, admittedly, the Bank has its hands somewhat tied. Fiscal policy, however, remains in the hands of Boris Johnson’s government. Blanchflower commented that “the question is whether a right-wing government has the will [to enact expansionary fiscal policy] or [whether it] will resort back to reckless failed austerity cutting rather than increasing public spending.”

Ultimately, both the Bank of England under Bailey and the government under Johnson have many challenges ahead of them as the U.K. hurtles towards a cliff-edge. Monetary policy itself is either constrained or set for a new era in which negative rates will prevail. Either way, all eyes will be on the Bank as Brexit unfolds.

(This article is up-to-date as of Jan. 6 2020)