23 March 2017

Bank of England: Brexit and the pound - speech by Ben Broadbent

Ben Broadbent, Deputy Governor of Monetary Policy, looks at the effect of Brexit on the pound. He discusses what economics has to say about its reaction to the referendum result and looks at depreciations impact on profitability and investment in the tradable sector.

The adjective “post-Brexit” is bandied around quite a bit these days. The term’s a bit previous. A better description of the UK’s current economic circumstances is “post-referendum” but “pre-Brexit”. 

The result is something of a sweet spot for exporters. Sterling fell sharply after the referendum and, despite the strength of consumption since then, has remained close to record lows. The most likely explanation is that the foreign exchange market believes that, when it does actually occur, leaving the EU will raise costs in the UK’s tradable sector. Whether this occurs through explicit tariffs, non-tariff barriers or lower productivity growth, the currency would need to be weaker in compensation. 

But the UK’s trading rules are for the time being unchanged. The result is that the costs and ease of exporting are unchanged but the returns to it significantly higher. With the world economy looking better than for some time the circumstances for the tradable sector could hardly be more propitious. One would expect firms in the more open parts of the economy both to use up any spare capacity and, in the normal course of events, to invest significantly more in that capacity as well. Over the longer run, this reallocation of resources is what the positive impact of an exchange-rate depreciation relies upon.  

It’s possible, of course, that Brexit won’t be as bad as the foreign exchange market appears to believe. If the government succeeds in negotiating a “new, comprehensive, bold and ambitious free trade agreement15” with the EU, and in opening up trade with non-European countries, the UK’s overall degree of openness may not worsen and it could improve. If so, and all else equal, the currency should in time rebound. 

But this makes longer-term investment in the tradable sector a somewhat tricky decision. Either the currency market is too pessimistic, in which case sterling’s depreciation is likely to be reversed over time. Or it’s not, in which case the costs of exporting will eventually go up. Barring some other source of exchange rate weakness, such as a sharp rise in the household saving rate (which would have its own implications for the economy), the sweet spot is unlikely to last indefinitely. So while investments with shorter-term payoffs make commercial sense, especially for those already running up against capacity constraints, the uncertainties involved in longer-term decisions could temper the usually positive response of business spending to depreciations in the exchange rate. Indeed they’re probably already doing so somewhat.   

In its latest forecasts the MPC expects this caution to persist. That’s why, in the central projection in the February Inflation Report, growth slows slightly this year, from 2.0% at the end of last year to 1.7% by 2017Q4. Though there are plenty of other variables to consider, the negative effects of the depreciation on consumption (via import prices and household income) are expected marginally to outweigh its more positive effects on other parts of demand.  

If only implicitly the consensus forecast seems to attach more weight to this Brexit-related caution. My guess is that financial markets do so as well. Despite higher profitability, business investment is projected to stagnate or fall this year even as it accelerates significantly further in other developed economies. The more negative effects on consumption clearly predominate and growth of aggregate demand is projected to slow reasonably sharply, to 1.2% by the end of this year.

Yet there are clearly risks to both. If businesses share the view of financial markets, and in particular the foreign exchange market, the risks around EU exit could persuade them to cut investment further this year. If they side more with consumers – who, as we’ve noted before, appear to have taken such uncertainties very much in their stride – they will respond more to today’s favourable conditions than to any caution about the longer-term future and instead raise investment spending.

Full speech

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