Brexit Dispute Risks Fanning Inflation and Pushing BOE Rate Rise
Britain’s debate about whether to walk away from post-Brexit commitments with the European Union over Northern Ireland risks unsettling an already sputtering economic recovery.
With the government in London threatening to invoke Article 16 of the Northern Ireland protocol, which governs trade in the region, economists warn that retaliatory measures from Brussels could hit exports and investments and deliver a further blow to the pound.
Those dangers give a sense of the jolt that may be coming if the U.K. opts to use a provision in the protocol allowing it to suspend some of the trade rules agreed when it left the EU. It also is likely to impact the Bank of England’s calculation about when to raise interest rates and address a surge in inflation.
“Clients weren’t interested in Brexit until last week, but now it’s back to square one -- they’re worried,” said Fabrice Montagne, the chief U.K. economist at Barclays Plc.
With both sides locked in talks to resolve the standoff, here are the key risks to the U.K. economy and how policy makers might react.
The Pound in Your Pocket
Market reaction to the U.K. triggering Article 16 will depend exactly how the government acts. A broad-based repudiation, with Britain “tearing up the Northern Ireland Protocol,” could prompt a quick 5% drop in sterling, Derek Halpenny, MUFG’s head of European global markets research, told Bloomberg Television.
In the longer term, the market could face an outlook that’s “persistently more uncertain and volatile,” with this particular dispute just one of many confrontations likely between the EU and the U.K, analysts at BofA Merrill Lynch wrote in a report.
Investors in sterling have already had to grapple with a number of headwinds to the currency in recent months. A surge in energy prices is slowing growth and boosting inflation, while uncertainty from the BOE on when interest rates will rise is damping investor sentiment.
A big blowup over Brexit could further unnerve the outlook and depress the pound.
Cue More Inflation
A weaker currency would push prices higher at a time when inflation is already running at more than the BOE’s 2% target.
New trade frictions “could amplify the supply shortages we have and pose lasting inflationary pressures,” said Jagjit Chadha, director of the National Institute of Economic and Social Research.
Those may be harder to ignore than the temporary factors like energy prices and the end of lockdown that the the BOE so far has pointed to in explaining why it can delay action. “The higher and longer inflation is above target, the more pressure there is for the Bank to respond to that,” Chadha said.
What Bloomberg Economics Says...
“A trade war would only stand to amplify the tricky trade-off currently facing the BOE. More uncertainty would add to the headwinds to growth while trade frictions and a weaker pound would give inflation another lift. The likely response? Probably a little less urgency to raise rates but it’s unlikely to prompt the BOE to ease like it did in 2016.”
--Dan Hanson, Bloomberg Economics.
More Pain for Businesses
The EU could retaliate by “enforcing ‘rules-of-origin’ checks much more strictly,” which would increase administrative burdens for exporters, said Jonathan Portes, a fellow at the Changing Europe research group. The EU also could revoke the data adequacy provision that lubricates trade.
It could also revive the uncertainty that followed the Brexit vote. “You would be worried about big investment decisions being put on hold, such as those in the car industry which were made on the assumption that the trade agreement remains in force,” Portes said.
“All the EU would have to do is say that it will suspend tariff-free access for car production if the U.K. does not comply with the protocol.”
Hopes of a trade deal with the U.S. might be one of the “first casualties” of Britain triggering Article 16, said Gerard Lyons, former economic adviser to Prime Minister Boris Johnson when he was mayor of London. A trans-Atlantic trade deal has long been held up as a potential key prize from Brexit.
But U.S. President Joe Biden is proud and vocal about his Irish heritage and has repeatedly raised concerns about any outcome that would threaten peace in the region.
Some pro-Brexit economists are less worried. Julian Jessop, an economics fellow at the Institute of Economic Affairs, a free-market group, said global pressures on energy and food prices would have a bigger impact on inflation -- and little influence on the BOE -- than any Article 16 action.
“It’ll come out in the wash,” Jessop said. “You’d get slightly higher inflation but weaker growth. The Bank hasn’t raised rates so far because of uncertainty about the real economy. If it gets another real-economy shock in the form of a trade war, that won’t cause it to raise rates any sooner.”
©2021 Bloomberg L.P.