British five and ten pound banknotes and one pound sterling coins sit in this arranged photograph in London, U.K. (Photographer: Chris Ratcliffe/Bloomberg)

Pound's Brexit Swing Threatens to Rip Up BOE's Inflation Outlook

(Bloomberg) -- The pound’s inevitable sharp move on the final Brexit outcome will have big implications for Bank of England policy.

Exchange-rate swings could push inflation up to almost 3 percent or slow it to well below the 2 percent target by early 2020, according to calculations by Bloomberg Economics. The direction will be determined by whether the U.K. leaves the European Union smoothly or without a divorce deal.

BOE officials, who are basing their forecasts on the average of a range of scenarios, have long said Brexit could lead them to move interest rates either up or down.

Pound's Brexit Swing Threatens to Rip Up BOE's Inflation Outlook

The currency has always been a barometer of Brexit developments, and was at $1.2992 on Tuesday, about 13 percent weaker since 2016’s referendum. In testimony to lawmakers last week, BOE Deputy Governor Jon Cunliffe said that sterling’s current value reflects a number of Brexit outcomes, and that large moves are possible once investors get clarity.

Foreign-exchange strategists surveyed by Bloomberg agree, with the median estimate showing that the pound could drop about 8 percent if the U.K. crashes out of the bloc without a deal. Or it could rally 6 percent if Prime Minister Theresa May finds a way to get her current plan through Brussels and Westminster.

Such a swing would translate to about a 1 percentage point difference in the BOE’s inflation forecasts a year after the currency movement, according to Bloomberg Economics’s Dan Hanson.

What Our Economists Say

“The BOE can be sure of one thing: It’s conditioning its forecasts on a level of sterling that won’t prevail once the outcome of the Brexit negotiations becomes clear. Deal or no deal, the pound will shift and take the inflation forecasts with it. In our central forecast, which assumes the U.K. gets a deal, we don’t think the move will be enough to prevent the BOE delivering two hikes next year but it will certainly give some on the MPC food for thought.”

-- Dan Hanson, Bloomberg Economics

BOE officials, who are due to announce their latest forecasts and policy decision next week, have hiked rates twice in the past year and say more increases are required. They are currently predicting a gradual decline in the inflation rate over their forecast horizon, returning to their 2 percent target in 2021.

Under a no deal scenario, the drop in the pound alone could add more than 0.5 percentage point to the inflation rate, Hanson estimates.

Assuming the decrease happened in the first quarter of next year, that would leave inflation approaching 3 percent by early 2020, even before the extra boost from tariffs and a potential slowdown in supply growth -- backing up Governor Mark Carney’s warnings that the BOE may have to respond to such an outcome with rate hikes.

“If we were to get no deal, sterling would have a long way to fall even though the market is short already,” said Jane Foley, head of currency strategy at Rabobank, who sees a 13 percent drop against the dollar in such an outcome. “That would be very worrying for the Bank of England.”

Conversely, the pound’s rally under a “good” Brexit would push inflation down by about 0.4 percentage point a year later, leaving the rate below officials’ target far sooner than they forecast.

The effect of just one aspect of Brexit -- in this case, the pound’s reaction -- shows how difficult a task the BOE faces in setting policy as talks drag on.

It also provides more evidence of how the current outlook, based on a Brexit with a smooth transition and little movement in the pound, is increasingly doubtful, and at risk of a major overhaul. Markets are currently pricing in just one more hike next year, though that could change quickly once Brexit negotiations conclude.

©2018 Bloomberg L.P.