Early response to the Brexit vote

Professor Robin Bladen-Hovell, Professor of Economics

With financial markets unwinding their immediate response to the decision to leave the EU, the initial dust from the referendum is beginning to settle and the nature of the likely short-term effect of the referendum on the economy is starting to emerge. While short of the gloom and doom prospects painted by the Remain Camp prior to the vote, the picture that is starting to take shape appears grim for the next few years at the very least with considerable opportunity for it to become grimmer should some of the downside risk-factors fall unfavourably.

The immediate response to the referendum result was a sharp decline in the UK stock market with the FTSE100 falling just over 5½% by June 27th while the broader FTS250 fell by just over 13½% in the same period. These effects, however, have been transient with the headline FTSE100 which represents larger, more internationalised, companies recovering within a week of the referendum and the FTSE250 eventually recovering the losses by August 5th.

Sterling also fell in the days following the referendum: 8% against the dollar and 6% against the euro. However, unlike the stock market movement, this decline has not been reversed as UK citizens who have travelled abroad over the summer have discovered to their cost. A falling, or depreciating exchange rate means that we receive fewer dollars or euros in exchange for our pounds than was previously the case or, put another way, each dollar or euro costs more sterling to acquire. Other things being equal, these changes make goods and services exported by the UK cheaper in foreign currency terms while increasing the price of goods and services imported into the UK, a potential stimulus to net exports and the demand for goods produced by the UK.

However, the overall benefits of this decline are likely to be small and temporary in nature. UK producers who depend upon imports for raw materials or components will find the benefits of the depreciation offset, at least in part, to the extent that depends upon the international character of their supply chain. Ford UK, for example, recently announced that 60% of their components for cars produced in the UK are imported from aboard with the result that increasing cost pressures will offset a significant portion of the benefit that otherwise flows from a lower exchange rate. Moreover, over time, the benefits of the depreciation will be offset more generally as domestic prices across the economy adjust to increased import costs.

Unfortunately, alongside the movement of the exchange rate, evidence is beginning to accumulate as to the deteriorating state of consumer and business confidence that was predicted ahead of the referendum. The evidence takes three forms: the sharp decline in the July Consumer Confidence Barometer produced by GfK NOP (UK) and the Markit/CIPS UK Purchasing Managers Index published for the same month and the equally dreadful results from the August CBI Business Confidence Survey. In each case either the headline figure or a key component recorded the sharpest decline since 2009 – in the case of the Consumer Confidence Barometer the 11 point decline represented the sharpest drop for more than 26 years.

Such movements suggest the onset of a slowdown in the economy with anecdotal evidence pointing the finger in large part to increasing economic uncertainty following the referendum. In the face of increasing uncertainly, households and firms are likely to delay decisions regarding expenditure generally and investment in particular, thereby reducing the level of aggregate demand in the economy and lowering growth.

Although no official economic data about the actual state of the economy has been published to confirm the onset of a slowdown in economic activity, or otherwise, City and other economic forecasters have in the main all revised down their predictions for the economy this year and next. Examining matched forecasts of output growth, produced by the same forecasters in June and July show, on average, a reduction in the growth forecast of 0.3% for this year and 1.6% for growth in 2017. Predictions for unemployment and inflation deteriorate similarly over the same horizon and the key factor influencing this worsening outlook is the referendum result.

This weakening of confidence seems to have played a key role in the decision by the Bank of England to relax monetary policy at last week’s meeting of the Monetary Policy Committee which cut the headline Base Rate to the historically low level of 0.25%. The cut was accompanied by a package of measures, including an Asset Purchase Facility known as the Term Funding Scheme, that are designed to ensure that banks pass-on the benefit of lower rates to households and firms. Despite this, however, the Bank of England’s actions are likely to have very little effect on the economy in practice. Base Rates have sat at 0.5% for since March 2009 so last week’s change is very small beer. Equally the relationship between interest rate policy and the economy is complicated and much more effective at constraining demand when policy is tightened than it is in expanding the economy when policy is loosened, sometimes compared with trying to move a weight with a piece of string: it works well when the string is tightened but doesn’t necessarily do much when the string is loosened.

While the current capacity for monetary policy to influence the economy is probably limited, changes in budgetary policy take longer to implement and are unlikely to be occur before the autumn should the slowdown in the economy be confirmed. This, in part, reflects the sensible decision to wait upon firm evidence of a slowdown in the economy and allowing its prospective depth to be assessed as well as judging whether it is likely to be temporary or more protracted. The delay also reflects the need for Philip Hammond, the new Chancellor to think through the detail of a new fiscal framework given George Osborne’s decision following the referendum result to abandon the budgetary target of running a surplus by 2019/20. The new framework will not represent an abandonment of austerity since government existing debt will still need to be repaid no matter what, but will have to reflect the new reality representing the changed circumstances following the leave vote. Any slowdown in growth will lead to tax revenues falling, worsening the deficit position and making that 2019/20 target less achievable. A discretionary stimulus, whether in the form of reduced tax rates or spending increases, will compound this with the result that the period of austerity will effectively extend beyond 2020.

All of this, of course, is before Article 50 is triggered and official negotiations to leave the EU commence. Only then will we begin to see what the Prime Minister meant by “a vote to leave is a vote to leave” and the precise shape Brexit begins to emerge. Taken together, all of this suggests that developments over the next couple of months will be critical.