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Berenberg’s Senior UK Economist, Kallum Pickering has issued a macroeconomic note looking back on the past year following the Brexit vote.
Here’s what he has to say:
Keep calm and carry on: Initial concerns of a collapse in short term demand after the UK voted to leave the EU – exactly one year ago today – have not materialised in a serious way. Real GDP growth has averaged a healthy 0.4% per quarter over the past year – only a notch below its historical trend. Sentiment among households and firms remains upbeat. As an open medium-sized economy the UK has benefited from the ongoing cyclical upswing in global demand. The c13% fall in trade-weighted sterling provides an extra cushion by making UK exports more competitive.
But all is not well: While the UK has largely avoided the short-run shock to demand, the risks to long-run supply from Brexit loom large. The immediate sharp fall in sterling after the Brexit vote was the consequence of markets cutting their expectations of the UK’s long-run growth prospects. The pound has remained weak over the past year despite the good economic performance. Until the risk of a hard Brexit is removed by clear evidence of progress in the UK-EU Brexit talks, sterling will remain weakened. In case of a hard Brexit, the UK’s potential real GDP growth rate could fall to 1.5%. Before the Brexit vote it was 2.2% – probably the highest in the G7. This difference will add up badly over time.
Lessons from the labour market: On the one hand, the continued rise in labour demand relative to supply since the Brexit vote – increasing vacancies relative to unemployment – reflects the robust state of the real economy. On the other hand, the hit to real wage growth from rising import costs serves as an early warning of the long-term damage Brexit will inflict on the UK economy. As our chart shows, real wage growth typically reflects supply and demand conditions in the labour market. The shock Brexit vote has temporarily forced a gap in this relationship.
Divisions at the Bank of England: With three MPC members – all known hawks – voting for a rate hike at this month’s meeting, the committee is currently divided between those concerned the BoE will overshoot its 2% inflation target unless it tightens now, and those that need more evidence of economic resilience before tightening. The BoE has not been so hawkish since 2011 when three MPC members voted for a hike – it never came. This week, BoE chief economist Andy Haldane said he expected to vote for a hike later this year. Meanwhile, the Governor Mark Carney said this week he doesn’t think economic conditions warrant a tightening just yet. Which way will the balance tip?
The case for rate hikes: Real wage growth is more volatile than the balance of demand and supply in the labour market – see chart. If labour demand holds up, as both we and the BoE expect, then real wage growth should rebound in time as nominal wage growth improves and import price inflation eases. But as one inflationary force eases another strengthens. With little slack in the economy, domestic inflationary pressures will prevent headline inflation from returning to the 2% target after the imported inflation passes. The UK could be ready for a rate hike soon.
A rate hike in 2017? The BoE faces inflation uncertainty stemming from the different speeds at which current demand and supply are reacting to Brexit. Communicating its policy guidance amid lower long-term growth adds to its challenges. We look for a first hike of 25bp in Q1 2018 with risks tilted toward a hike sooner. We see a 40 per cent chance of a rate hike before this year is over. A continued tightening thereafter will be very, very gradual.