Bank of England says Brexit will shape UK's economy

The Bank of England’s Monetary Policy Committee (MPC) meeting last week concluded with the central bank increasing interest rates for the first time since July 2007.

The MPC announced an increase in the bank rate of 25 basis points, bringing it to 0.5%.

A majority of MPC members — seven to two — considered it “appropriate to tighten modestly the stance of monetary policy in order to return inflation sustainably” to its 2% target.

The rate rise reverses the 25 basis points cut that the BoE introduced following last summer’s Brexit referendum.

This rate hike from the Bank of England had been expected after the bank had teed up markets at its previous meeting, back in September, that its tolerance for above-target inflation was diminishing and that a rate hike would likely be required in the coming months.

The November meeting statement and minutes outlined the MPC’s rationale for the decision to raise the bank rate. The committee noted that spare capacity in the economy had eroded, while at the same time, underlying inflationary pressures were showing signs of picking up.

It also stated that it had become “increasingly evident that the pace at which the economy could grow without generating inflationary pressures had fallen”.

The Bank of England said that the steady erosion of slack had reduced the extent to which the central bank could accommodate an extended period where inflation overshoots the 2% target. UK inflation reached 3% in September.

In its assessment of the economy’s current performance the bank noted that the decision of the UK to leave the EU was already having a “noticeable impact”.

This was evident in the overshoot in inflation arising mainly as a result of the effect on import prices from the referendum-related fall in sterling.

The bank also commented that uncertainties associated with Brexit were “weighing on domestic activity”.

The Bank of England’s updated set of macro forecasts contained in the November inflation report, which assume a “smooth Brexit adjustment”, were broadly similar to its previous projections back in August.

The bank revised slightly lower its 2017 GDP forecast to 1.6% — from 1.7%.

It anticipates growth of 1.6% in 2018 and 1.7% in 2019.

In terms of the inflation outlook, the MPC continues to expect it to peak above 3% in the third quarter of this year as the past depreciation of sterling and recent increases in energy prices continue to impact consumer prices.

The bank envisages that inflation will approach its 2% target by the end of 2020.

The bank also placed a strong emphasis on Brexit being the “biggest determinant of the outlook”.

It listed the potential impact on the response of households, businesses and financial markets to Brexit-related developments, as well as the fact that its withdrawal from the EU will redefine the “UK relationship” with its “largest trade and investment partner”.

Overall, while the Bank of England has hiked interest rates for the first time in a decade, the extent of policy tightening over the next two-to-three years is likely to be very modest.

Indeed, governor Mark Carney stated that the MPC expects that any future increase will be at a “gradual pace and to a limited extent”.

Futures contracts suggest that the market expects two additional 25 basis points increases by the end of 2020. These contracts are currently pricing in another increase by the end of 2018, with a subsequent increase not priced in until 2020.

This represents a very modest pace of rate hikes and the Bank of England appeared to be content with the market view by dropping its previous reference to the fact that rates may have to rise by a somewhat greater extent than market expectations.

John Fahey is a senior economist at AIB

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