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A long haul to Brexit and beyond

The strong performance of the United Kingdom economy in the last quarter has little to do with the long term impact of Brexit. That depends on the kind of exit deal we get and the trade deals which replace European Union membership. The longer the government flails around on the issue, the more the uncertainty will damage confidence in the UK economy.

The first official estimate of GDP in the three months to September shows the economy expanded by 0.5 per cent. That is a much stronger performance than many economists had expected. Growth was driven by the services sector while other sectors shrank. Within services, the leisure and transport sectors performed particularly well, suggesting that households remained confident in contrast to businesses. Over the year, GDP was 2.3 per cent higher which is a creditable performance compared to other rich countries. However it does not give us much indication about what will happen next.

The debate about the economic impact of Brexit has confused short and long term effects. Before the referendum, a number of forecasts predicted that the potential Brexit options would reduce the future growth of the UK economy. This was mainly because international trade would cost more outside the EU; overseas companies would see the UK as a less attractive country in which to invest, particularly if there was little or no access to the single market; and because immigration would be curbed to a damaging extent. These risks remain, and are significant.

It was assumed by some forecasters that a vote to leave would be negative in the short term. Investors would extrapolate from the long term impact they expected and that would hit the economy immediately. This would be seen in selling of the pound, with rising long term interest rates as government bonds were sold. In addition, risk premia would rise; in other words interest rates on mortgages and business loans would rise even more. In the event, sterling did fall heavily but long term interest rates fell. This was partly because investors assumed the Bank of England would step in, which it duly did with an interest rate cut and new quantitative easing. Business surveys showed a massive and recessionary drop in confidence took place in July, but things were better in August and September. Despite the ongoing criticism of the Governor, the Bank was right to get a grip when everyone else was flapping around.

However, the long term concerns had not altered. Indeed, rhetoric from government ministers has pointed to a ‘hard Brexit’. In markets, this has been interpreted as making it more likely that we come out with a worst case scenario. As a result, sterling has been sold off further and expectations of higher inflation have been pushing up long term interest rates ahead of other markets. In August the government could borrow for ten years at a cost of around 0.5 per cent per annum; now it will cost over 1.2 per cent per annum, which is only back to pre-referendum levels but a significant move.

Recorded inflation is already rising, partly because past falls in oil prices are falling out of the annual figures, which is nothing to do with Brexit. But the fall in sterling is pushing up import prices, including for food and fuel. Unless companies are more confident about the future and believe that demand will increase, they will be reluctant to pass on all of the higher input costs to higher prices for their products and services. So profit margins will get squeezed, along with household living standards as wage growth fails to keep up.

This is only the beginning of the story. There will be periods of optimism and pessimism before we get to Brexit and beyond. Nor is a fall in sterling always a bad thing. It is an adjustment, which comes with costs and benefits; government needs to be proactive in responding. The bigger problem is that this government is increasing the uncertainty, which risks a loss of confidence in the UK, damaging our long term future while hitting households now.

The latest GDP data show the economy did not fall off a cliff in the summer, partly because the Bank of England stepped in. The government now has to outline a credible post referendum economic policy. The Nissan deal is good for jobs but raises doubts about whether the government is capable of constructing a consistent approach to Brexit. A progressive alternative has to promote growth, be in favour of markets and trade and friendly to enterprise, but in ways which work for everyone.

This article was first published by Progress on 1 November 2016.

Progress, 1 November 2016, 13/11/2016

Not an easy task given uncertainties, especially if energy and commodity prices do fall later in the year. Ultimately, radical economic reform required.
Central banks are struggling to head off general inflation while dealing with price shocks that will be negative for growth. They waited too long, which has made their tasks more difficult.
The Bank of England has raised interest rates, but that does not mean it has been most effectively managing inflation risks.
The Bank should signal it will act if higher prices look likely to translate to higher inflation rate.
The IMF's Fiscal Monitor is actually quite radical.
Spare a thought for finance ministers, and the opposition counterparts who aspire to replace them. The conventional wisdom was that they should at least make an attempt to follow fiscal rules. Now, there are no rules.
My letter in the Financial Times on the need for a framework for economic policy decision-making.
Responding to Brian Griffiths' article in The Article on the risks of inflation.