The Bank of England has warned that there is no guarantee it would cut interest rates to support growth and jobs under a disorderly Brexit and said it might have to raise borrowing costs instead.
In its quarterly health check on the economy, Threadneedle Street’s governor, Mark Carney, said he still expected London and Brussels to come to an agreement. However, he added that it should not be assumed that the Bank’s monetary policy committee would respond to a chaotic Brexit by repeating the cut in interest rates it delivered after the EU referendum in 2016.
Carney said that the MPC would assess the impact of a no-deal Brexit on the demand for goods and services, the supply-side potential of the economy and the value of the pound before deciding on its response. Only if the shock to demand were greater than that to supply would it cut rates.
“Since the nature of EU withdrawal is not known at present, and its impact on the balance of demand, supply and the exchange rate cannot be determined in advance, the monetary policy response will not be automatic and could be in either direction,” the governor said.
A threat to increase interest rates by the MPC will add pressure on the European Research Group of Tory MPs, who currently prefer adopting World Trade Organization trade tariffs to accepting Theresa May’s Chequers deal.
James Smith, economist at banking group ING, said it was far more likely that rates would be cut if negotiations ended in failure. “In a ‘no deal’ scenario, the Bank has suggested rates could go in either direction. However, given the wide-scale disruption that would likely occur, we suspect policymakers would ‘look through’ any spike in prices caused by a weaker pound, and cut interest rates or increase quantitative easing fairly swiftly.”
Lenders have already bumped up the cost of fixed rate mortgages ahead of the Bank of England’s decision to raise base rate from 0.25% to 0.5%, and mortgage borrowers on tracker and variable rates will see their monthly payments become more expensive in the coming days.
Savers will gain as banks and building societies improve the rates available on deposit and Isa accounts, although increases are unlikely to come for several weeks.
How much consumers and businesses cut back on spending and investment in the face of higher rates will depend on signals from the Bank about the trend for future increases.
Carney said the Bank was working on the basis that there would be an agreement, because both the UK and the EU wanted one.
Announcing the latest decision of its rate-setting committee on Thursday, the Bank said the MPC voted unanimously to keep the base rate at 0.75%. On the assumption that there is a smooth Brexit, the MPC thinks it will need to raise rates gradually from their current level of 0.75% in order to keep inflation close to its 2% target. Threadneedle Street believes businesses will unlock investment that has been put on hold while there has been uncertainty about the future UK-EU relationship, pushing growth up from 1.5% in 2018 to 1.7% in each of the next two years.
Apart from Brexit, the MPC expressed concern that the slowdown in the global economy and the impact of the US-China trade dispute would have an impact on the UK. The inflation report cited weaker GDP growth across the eurozone and in China over recent months. Several large developing world countries have also seen their growth rates tumble, leaving the US as one of the main pillars keeping global rates from falling below their recent average.
“A broad-based increase in barriers to trade between countries could have a material impact on global activity and, in turn, on the UK economy,” it said.
In the UK, the job market has strengthened since the Bank’s last quarterly report in August and wages have risen more strongly than expected. Wage increases are expected to push up prices in the shops over the Bank’s forecast period of the next two to three years.
However, offsetting this trend is a more subdued increase in import costs compared with last year, when a slump in sterling pushed up imports prices at a faster rate.
The Bank said its quarterly inflation report, which it published alongside the interest rate decision, was finalised before Philip Hammond’s budget on Monday and had therefore excluded the chancellor’s spending plans. But it is understood that the Bank would consider Hammond’s budget to be a mild economic stimulant that could mean interest rates rise faster than expected.
At the moment, the MPC is expected to increase the base rate once in each of the next three years, though the financial markets, which are increasingly fearful of a no-deal Brexit, only anticipate two rate rises over that period.
Central bank officials have for some time expected the government to secure an agreement with Brussels that will pave the way for a trade deal, leaving the import and export of goods and services little changed. This remains the government’s policy and the Bank believes it has little choice but to base its forecasts on this scenario.
