Watching for storm clouds
16 January 2018
The economic outlook does little to set the pulse racing at present, with growth expected to trundle along in 2018. However, things could always be worse. Our slow but steady scenario rests on the assumption that consumers remain resilient in the face of rising interest rates, an inflation squeeze and Brexit uncertainty. Businesses, meanwhile, are expected to hold their nerve as the end to Article 50 comes into sight, helped in some areas by a strong global growth backdrop. Finally, while Brexit negotiations will remain bumpy, we would expect continued progress towards a transition arrangement and eventual trade deal with the EU.
What would happen if these supportive foundations were to fracture? Let’s start with the global backdrop. Imagine that tighter monetary policy across a range of economies put the brakes on the nascent global upswing. This would snuff out one of the brighter spots in the UK economy, with strong global trade having seemingly provided a boost to net exports over recent quarters (see Chart 4). This deterioration would also have indirect effects too, particularly on business investment projects sensitive to external demand. Finally, the tougher global backdrop that we have envisaged would incorporate rising financial stress, which would transmit to the UK economy through a number of channels. The most interesting of these might be the currency. In an environment of deteriorating global growth, rising volatility and US dollar appreciation, it seems unlikely that a currency like sterling, with a large current account deficit, would perform well (see Chart 5). If sterling were to depreciate materially in trade-weighted terms, the UK would face another round of imported inflation. This would be bad news for the nation’s embattled households. With savings already close to record lows, credit conditions tightening, house prices stagnating and sentiment already fragile there is already a risk that consumers start to retrench as the Bank of England raises interest rates in 2018. A more cautious mindset would surely be exacerbated by another bout of income-squeezing inflation. In one fell swoop we could be looking at weaker household consumption, export growth and business investment over the next 12 months.
These financial and growth shocks would intensify if Brexit negotiations hit rocky ground. With the Article 50 clock ticking, roadblocks at this stage could lead to a more pronounced shift in corporate and consumer behaviour to prepare for this shock. This could include shelving capex projects, or even shifting selected activities abroad to shield themselves from a fall back to WTO trade rules. Furthermore, this environment would likely put even more pressure on the pound, as investors shy away from UK assets. The combination of higher political uncertainty and rising inflation would clearly be a difficult one for consumers. Unfortunately, monetary policy might not provide an offset in the downside scenario outlined here. The Bank has repeatedly expressed its concerns around the trade-off between higher inflation and lower growth in the wake of the Brexit shock. Indeed, if it judges that the deterioration in activity again represents a shock to both demand and supply, it may feel unable to loosen policy, leaving the economy to fend for its self. These developments are certainty not our central scenario, but looking at downside risk helps provide a useful reminder around where the economic and institutional vulnerabilities lie.