Economy needs political stability not just rate cuts

The lower interest rates promised by Mark Carney yesterday aren’t a magic cure for the economic damage caused by Brexit. They mean a cheap pound and higher inflation. If political turmoil continues, rates may even need to go up.

After the abuse the governor of the Bank of England received during the referendum, he might have thrown his hands in the air, got on a plane to Canada and left us to fix our own mess. But that would have shown Carney was not strong enough to run an independent central bank. Fortunately, he seems made of sterner stuff.

But there is only so much the Bank can do to alleviate the damage. Part of the governor’s plan is “ruthless truth telling”. And an “uncomfortable truth is that there are limits to what the Bank of England can do. In particular, monetary policy cannot immediately or fully offset the economic implications of a large, negative shock”.

Even if cutting rates helps cushion the economy, the value of the pound will stay low. That pushes up the cost of living. Sterling has already fallen 10% against the dollar since the night of the referendum. If it drops another 2.3% against the euro, Britain will have lost its status as the world’s fifth largest economy – something Brexiteers used to crow about.

Meanwhile, mortgage-holders shouldn’t count their lucky stars. While a cut in the bank rate benefits borrowers, lower growth and higher unemployment might see lenders requiring higher repayments from borrowers, increasing their mark-up on the Bank rate. All this would make it harder for youngsters to get on the housing ladder.

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A falling pound also means that Bank will miss its inflation target of 2%. It may rise to around 4%. While it is reasonable for the Bank to treat this as a short-term blip, that calculation would change if the government lost credibility with the markets. Our large current account deficit makes us especially vulnerable to investors’ nerves.

This isn’t the main scenario for now. After all, if markets thought interest rates were due for a rise, then bond yields would be increasing. Instead, they have fallen to record lows, pointing towards expectations of lower interest rates for a longer period.

But if our divorce negotiations with the EU get bitter, things could change. Investors could also get twitchy because George Osborne has today abandoned the government’s plans for reining in its high budget deficit – a policy u-turn backed by both Theresa May and Michael Gove, the front-runners to become prime minister.

While such a policy is reasonable as a measure to cushion the downturn, it is only sustainable if the government doesn’t lose the confidence of investors. All the more reason why Britain needs a new prime minister who will steady nerves. May looks a much better bet on that score than Gove.

Edited by Hugo Dixon