Expert View

Brexit supply shock may cause more interest rate rises

by George Magnus | 02.11.2017

George Magnus is the former Chief Economist of UBS and Associate at Oxford University’s China Centre.

The decision by the Bank of England’s Monetary Policy Committee to increase interest rates from an all-time low of 0.25% to 0.5% – the first rise in a decade – sends out an important signal, not least in the Brexit process.

There are, of course, several legitimate economic reasons for leaning in favour or against the Bank’s decision. These relate mainly to whether the rise in inflation is temporary or not, how much slack there is in the labour market, if high household debt should be the Bank’s concern, and how and why investment spending needs to strengthen.

If economists cannot agree on these matters, imagine the arguments they have about what the Bank should or shouldn’t be doing based on the all-consuming issue of Brexit. An understandable response would be to throw up one’s hands in despair on the basis that no one can predict the path towards Brexit, or even the longevity of the government that is negotiating it, let alone the consequences. Policymakers, including at the Bank, though, are not allowed this indulgence.

There is a way to think about Brexit and monetary policy though. Before the referendum, the Bank and the Treasury assumed Brexit would have a demand shock on the economy, that has patently not happened. It might yet occur if there were a sudden, no-deal and politically acrimonious Brexit, but policymakers can only address it if it happened.

Economists were correct, however, to point out that Brexit would have a different impact, a so-called supply shock, that would be more corrosive than instant, and more enduring than temporary. In other words, it will compromise the economy’s potential rate of growth through its impact first on confidence, and then on disruptions to trade, investment and productivity. This below-the-radar impact is already gathering a bit of momentum. For the Bank, it is like discovering that a car’s maximum speed limit before it starts rattling – or in the case of the economy, inflation emerges – is significantly lower than it used to be.

The Bank’s concern, then, likely to be corroborated by the Office for Budget Responsibility later this month, is that productivity growth and the economy’s trend growth will not revert to past performance, and that inflation may therefore not behave as expected. The current signs of this supply shock are evident, if not alarmist. The place to look for actions to affect or mitigate the economic consequences, though, is Whitehall, not the Bank’s headquarters in Threadneedle Street.

Today’s Bank move won’t change the country’s economic outcomes decisively. It has sent a shot across the bows, though, to individuals, companies, and financial markets that have come to depend on basement level interest rates, which is no bad thing. The key now is what happens to interest rates in 2018 and 2019. If the Bank continues to raise them, it would be doing so more because of the Brexit supply shock than because of the economy’s resilience.

Edited by Hugo Dixon