Brexit brings with it fresh inflation headaches for UK

The EU looks to be leaving the door open for a deal that could avoid some of the major downsides of a ‘hard’ Brexit, writes Oliver Mangan

The Bank of England may be regretting that it cut rates last summer in the aftermath of the UK vote to leave the EU, given that the British economy has held up much better than expected and inflation has picked up sharply on the back of the big fall in sterling.

The March meeting of the Bank of England’s Monetary Policy Committee (MPC) concluded with no changes to policy. However, one member was of the view that inflation was rising quickly and likely to remain above target for at least three years and, thus, voted for a rate increase.

The other eight members, though, considered the current stance of monetary policy to be appropriate, noting that Brexit still posed a downside risk to the economic outlook.

Nonetheless, the meeting minutes showed that, for some members, it would take relatively little further upside news on the prospects for activity or inflation for them to consider tightening policy.

The BoE’s most recent set of macro forecasts were contained in February’s Quarterly Inflation Report. It upgraded its 2017 GDP growth forecast from 1.4% to 2%.

It is forecasting growth of 1.6% in 2018 and 1.7% in 2019.

On the inflation front, the MPC’s forecasts were broadly unchanged, as it continued to expect inflation to peak at around 2.8% in 2018.

However, the February inflation figures published last week will be a worry for the Bank.

Consumer prices rose by a stronger-than-expected 2.3% in annual terms, while the core rate, which excludes energy and other volatile components, jumped to 2%.

The Bank has highlighted the difficult trade-off that it must try and balance in its policy deliberations.

This is between the speed with which it intends to return inflation to its 2% target and the support that monetary policy provides to jobs and activity at a time of much uncertainty.

Nonetheless, the Bank continues to emphasise that there are “limits to the extent that above-target inflation could be tolerated”.

The markets are taking note. Sterling has firmed in the past fortnight while futures contracts are now pricing in a rate hike in the UK for the second half of 2018.

We are of the view, though, that a rate hike around then is unlikely as the UK will be in the middle of difficult Brexit negotiations.

In this regard, a speech last Wednesday given by Michel Barnier, the EU’s chief negotiator on Brexit, got surprisingly little publicity given its content and importance.

He indicated that the EU is very much up for reaching a broad free-trade agreement with the UK, but this must be based on “a level playing field” in areas such as the environment, taxation, labour law and consumer rights that avoids “regulatory dumping”.

He recognises that this could take time to agree, so there may be a need for transitional arrangements when the UK leaves the EU.

But these cannot amount to a cherry-picking of the Single Market and must be subject to European law.

He warned of dire consequences if no deal is done and stated that “the no deal scenario is not our scenario. We want a deal”.

However, Mr Barnier also indicated that before the EU can move to discuss trade and its future relationship with the UK, there must be agreement first on the “principles for an orderly withdrawal”.

These include guaranteeing EU and UK citizens’ rights post-Brexit, settling the financial accounts and dealing with the new borders of the EU, in particular Northern Ireland.

Mr Barnier’s strong signals on the benefits of reaching a deal with the EU echo sentiments expressed by other senior European politicians, such as the German Finance Minister, Wolfgang Schauble.

Obviously, the exit talks will be difficult.

However, the EU looks to be leaving the door open for a deal that could avoid some of the major downsides of a ‘hard’ Brexit.

Oliver Mangan is chief economist at AIB