20 November 2017

VoxEU: The consequences of the Brexit vote for UK inflation and living standards: First evidence

This column asks how much of the rise in inflation is due to the referendum. It finds that the referendum result pushed up UK inflation by 1.7 percentage points, which amounts to an annual (and potentially permanent) cost of £404 for the average British household.

Actual costs rather than forecast costs

In recent research (Breinlich et al. 2017a), we do not forecast the potential effects of Brexit. Instead, we analyse the effects that have already materialised. We exploit the notion that the result of the referendum vote in June 2016 took most people (including financial markets) by surprise. As soon as the outcome became clear, the pound depreciated sharply. This decline persisted in subsequent months, with sterling still around 10% below its pre-referendum value by November 2017, as shown in Figure 1.

From a researcher’s point of view, the referendum and the resulting depreciation of sterling can be regarded as an exogenous macroeconomic shock that was sudden, strong, and persistent. Our research is the first attempt to trace out the economic consequences of the referendum shock using detailed econometric analysis.

From an exchange rate depreciation to inflation

Economic theory predicts that a strong and sustained depreciation of a country's exchange rate should lead to an increase in inflation. In fact, CPI inflation in the UK rose from 0.4% in June 2016 to 2.6% in June 2017 and 3.0% in October 2017.

But it could be that inflation rose over this period for reasons that are entirely unrelated to the referendum shock, for instance a rise in the global price of oil and other commodities. In fact, inflation also increased in the US and the Eurozone after June 2016 as shown in Figure 2. It would therefore be wrong to attribute the entirety of the rise in inflation to the referendum shock.

We deal with this challenge in two ways. First, we compare the UK inflation experience to that in the Eurozone. Second, we use the fact that different types of goods depend to different degrees on foreign imports. For example, imports account for a large share of final consumer expenditure on clothing, footwear, and furniture. By contrast, the cost of housing (rents), education, restaurants, and hotels is not much influenced by the price of imports. So, if the depreciation of the pound was responsible for the increase in UK inflation, we should observe larger increases for goods that are more dependent on imports. To measure import dependence, we calculate the share of imports in consumer expenditure for different products, taking account of both final good imports and imported inputs used by UK producers.

Import exposure and inflation

[...]Accounting for differences in product-specific inflation rates that are unrelated to Brexit (such as oil price movements and global inflationary pressures that also led to changes in inflation elsewhere), we find that product groups with higher import shares experienced significantly higher inflation following the referendum. Our estimates imply the Brexit vote increased UK CPI inflation by 1.7 percentage points in the year following the referendum. It would be wise to view the precise magnitude of this effect with some caution, but it is clear that the effect is substantial.

Consequences for households’ living standards

We next look at the impact of higher prices on household expenditure and living standards. We find that the average household has to spend £7.74 more per week, or £404 more per year, to afford the same purchases. By increasing prices without affecting nominal wage growth, the referendum has also reduced real wages, costing the average worker almost one week’s wages (4.4 working days’ wages, to be precise).

It is clear that the average British household is already paying a price for voting to leave the EU. But not all households are equally affected. Households that buy a lot of imported goods have faced bigger price rises than households that mostly purchase products produced in the UK. This allows us to study the distributional consequences of the Brexit vote.

We find that the inflation increase is shared evenly throughout the income distribution but not across regions. [...]

Full article on VoxEU

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