Rate call on track, a Brexit transition into the unknown - Capital Economics
UK Economics

Rate call on track, a Brexit transition into the unknown

UK Economics Weekly
Written by Andrew Wishart

Thursday’s interest rate decision was a good first step on the road to vindicating our view that interest rates won’t be cut this year. And the Bank’s new forecast suggests that the bar to a rate cut is higher than you might assume. Meanwhile, Brexit at 11pm tonight has some immediate political consequences. But the 11-month status quo transition period means the direct economic impact will be nil until 31st December 2020. A more distant economic relationship with Europe thereafter will be another headwind to productivity growth, but in the grand scheme of things it won’t be a large one.

Our interest rate call clears the first hurdle

While some may raise a glass to the UK leaving the EU tonight, we will be toasting our call that interest rates would not be cut from 0.75%. (See here.) But our view that rates won’t be cut at all this year is not yet vindicated. New Bank of England Governor Andrew Bailey’s first meeting on 26th March and those that follow will be “live” as the MPC watch the data for confirmation that the improvement in the surveys for January is an accurate reflection of economic conditions. There is still a 77% chance of a rate cut this year priced into the market.

Note, though, that the bar to keeping rates on hold is not as high as you might think. The downgrade to the Bank’s forecast in January means the Committee is looking for GDP growth of only 0.2% q/q in Q1 and 0.3% q/q in Q2. We expect the economy to exceed the Bank’s expectations. (See Chart 1.)

After all, as we set out in the UK Economic Outlook published on Tuesday, the loosening in fiscal policy announced in the September Spending Round will kick in from April. And we suspect the upside risk to the Bank’s forecast that “the upcoming Budget [on 11th March] may be expansionary” will crystallise.

Chart 1: GDP (% q/q)

Sources: Refinitiv, BoE, Capital Economics

Of course, the negotiations between the UK and the EU on their future relationship have the potential to undermine sentiment. But our base case is that the UK and the EU take steps to prevent a disruptive change in their relationship on 31st December 2020. (See here.) As a result, we are comfortable with our view that the MPC won’t deliver the rate cut that investors anticipate and will instead raise rates in 2021. (See here.)

The long-run consequences of Brexit in context

While Brexit at 11pm tonight has some immediate political consequences, the 11-month status quo transition period means the direct economic impact will be nil until 31st December 2020. The most likely outcome of a “Canada, plus, plus” trade deal may knock 0.3ppts off annual GDP growth, meaning that the economy would be about 4% smaller in 15 years’ time than it would have been if the UK had stayed in the EU. (See here.)

In the context of the UK’s productivity problem that would be just a speck on the landscape. In 2014 the MPC expected annual productivity growth to be 1.2ppts higher than it has been since! (See Chart 2.) If it was right, the economy would be 8% larger now.

Chart 2: Output Per Hour Worked (2016=100)

Sources: Refinitiv, BoE

The effect of Brexit could easily be offset by other developments. We believe that over the next 10 to 20 years the UK will start to feel the benefits of the digital revolution. As Governor Mark Carney quipped in his parting press conference, “computers were everywhere but the productivity statistics, until they started showing up [there] quite dramatically.”

The week ahead

We suspect that the final January activity PMIs released Monday through Wednesday will confirm that the economy rebounded at the start of the year.


Data Previews

IHS Markit/CIPS All-Sector PMI (Jan.) Wed. 5th Feb.

Forecasts

Time (GMT)

Previous

Consensus

Capital Economics

All-Sector PMI

09.30

48.9

52.8

The post-election rebound may not be as strong as the PMIs suggest

A likely increase in the all-sector PMI – to a level in January that is consistent with GDP growth rising to 0.3% q/q – should provide the MPC with further reassurance that a rate cut in the coming months is not needed.

The flash services PMI strengthened in January from 50.0 to a 16-month high of 52.9. And we wouldn’t rule out an upward revision to the index – it has been nudged up by 0.7 points on average in the past four months and by 0.1 point since the series began. We have pencilled in an increase to 53.5. Revisions to the flash manufacturing PMI tend to be more modest though, so we are not expecting any change to January’s flash estimate of 49.8.

We expect to see evidence of a post-election rebound in the construction PMI too, perhaps taking it from 44.4 in December to 47.5. Altogether, this should push up the all-sector PMI from 48.9 to 52.8. That would be consistent with a rise in GDP growth from a probable -0.1% q/q in Q4 to +0.3% q/q in Q1. (See Chart 3.) Actual GDP growth may not be quite that good. Like the Bank of England, we envisage GDP growth rising to +0.2% q/q in Q1.

Chart 3: All-Sector PMI & GDP

Sources: IHS Markit, Refinitiv, Capital Economics


Economic Diary & Forecasts

Upcoming Events & Data Releases

Date

Country

Release/Indicator/Event

Time (GMT)

Previous*

Consensus*

CE Forecasts*

UK Data Response

Mon 3rd

UK

IHS Markit/CIPS Manufacturing PMI (Jan, Final)

(09.30)

49.8p

49.8

49.8

Tue 4th

UK

IHS Markit/CIPS Construction PMI (Jan, Final)

(09.30)

44.4

48.0

47.5

Wed 5th

UK

New Car Registrations (Jan)

(09.00)

(+3.4%)

UK

IHS Markit/CIPS All-Sector PMI (Jan, Final)

(09.30)

48.9

52.8

DR

UK

IHS Markit/CIPS Services PMI (Jan, Final)

(09.30)

52.9p

52.9

53.5

DR

Thu 6th

No Significant Data Released

Fri 7th

No Significant Data Released

Selected future data releases and events

Tue 11th

UK

GDP (Q4, Prov., q/q(y/y))

(09.30)

+0.4%(+1.1%)

DR

UK

GDP (Dec)

(09.30)

-0.3%(+0.9%)

DR

UK

Industrial Production (Dec)

(09.30)

-1.2%(-1.6%)

DR

UK

Construction Output (Dec)

(09.30)

+1.9%(+2.0%)

DR

UK

Trade Balance (Dec)

(09.30)

+£4.0bn

DR

*m/m(y/y) unless otherwise stated, p Provisional reading from the flash PMI

Sources: Bloomberg, Capital Economics

Main Economic & Market Forecasts**

%q/q(%y/y) unless stated

Latest

Q4 2019

Q1 2020

Q2 2020

Q3 2020

Q4 2020

2019

2020

2021

GDP

+0.4(+1.1)

-0.1(+0.8)

+0.2(+0.4)

+0.4(+1.0)

+0.5(+1.1)

+0.5(+1.7)

(+1.3)

(+1.0)

(+1.8)

Household spending

+0.3(+1.1)

0.0(+0.9)

+0.5(+1.2)

+0.5(+1.2)

+0.5(+1.5)

+0.4(+1.9)

(+1.2)

(+1.5)

(+1.6)

CPI inflation (%)

(+1.3) (Dec)

(+1.4)

(+1.9)

(+1.4)

(+1.3)

(+1.6)

(+1.8)

(+1.6)

(+1.7)

ILO unemployment rate (%)

3.8 (Nov)

3.9

4.0

4.0

3.9

3.9

3.9

3.9

3.8

Bank rate, end period (%)

0.75

0.75

0.75

0.75

0.75

0.75

0.75

0.75

1.00

10 yr gilt, end period (%)

0.53

0.82

0.70

0.80

0.90

1.00

0.82

1.00

1.25

$/£, end period

1.31

1.33

1.33

1.34

1.35

1.35

1.33

1.35

1.40

Euro/£, end period

1.19

1.18

1.21

1.23

1.26

1.29

1.18

1.29

1.33

Sources: Capital Economics, Refinitiv

** Assumes the UK and the EU agree some kind of fudge that means there is not a big step change in their relationship on 31st December 2020. See our UK Economics Outlook, “Turning the corner”, for more detail.


Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com