Living standards· Brexit & trade Are we set for a Brexit-induced cost of living crisis? 28 June 2016 by Matthew Whittaker Matthew Whittaker What impact will Brexit have on living standards? It is of course far too early to make any sensible assessment about the longer-term picture, particularly as this will depend on the details of the UK’s new relationship with Europe. But clearly the world has already changed. The business and consumer uncertainty generated by last week’s vote and ongoing financial turmoil means that there will almost certainly be some negative fallout – at least in the short- to medium-term. In terms of employment and earnings – the most direct mechanisms by which incomes are affected – it’s likely to be a few months before we get a clear sense of the magnitude of the impact. We can, however, start to make some tentative estimates of the likely cost of living effect associated with recent events. Again the details matter, but the sharp depreciation in sterling – it fell by 9 per cent between Thursday and Monday, is 15 per cent down year-on-year and reached a 31-year low against the dollar – will inevitably make imports more expensive. As well as the obvious direct effect of that on the prices faced by UK households, increased production costs for domestic producers will provide a further push to the overall price level. What might this mean in the real world? The Bank of England’s broad rule of thumb is that somewhere between 20 per cent and 30 per cent of exchange rate movements feed through to the CPI over the medium term. With many economists anticipating the depreciation to settle somewhere between 10 per cent and 20 per cent, that implies a central estimate for an increase in CPI in the range of 3-4 percentage points above the counterfactual. However, as recent work by Kristen Forbes and others has shown, the scale of the pass-through is likely to depend on what has driven the exchange rate shock in the first place. Looking specifically at the effect of Brexit, NIESR’s pre-referendum modelling suggested that CPI would rise by around 1.5 percentage points overnight, climbing to around 2.7 percentage points by the middle of 2017. That was broadly in line with the HM Treasury analysis which put the peak effect at 2.3 percentage points within one year. Comparing this with the OBR’s projection for inflation in 2017 at the time of the March Budget implies that CPI might top 4 per cent next year. Absent any other effects (in relation to employment, pay, investment and monetary policy for example) such an increase in inflation would bear down on the living standards of workers and those in receipt of working-age benefits such as tax credits (which are subject to a nominal freeze through to 2019). Purely by way of illustration, we can consider a couple with two earners (one full-time and one part-time) and two children. Sluggish wage growth and cuts to tax credits mean that they would already have faced a 2 per cent reduction in net income next year relative to this (falling from £30,100 to £29,500). An increase in inflation of the magnitude set out above would roughly double the scale of their year-on-year loss to 4 per cent (or £1,300). Of course such effects – repeated across a large number of households to greater or lesser degrees – would be likely to dampen domestic demand, making the inflationary spike relatively short lived. However, the associated contraction in consumption might be expected to continue to pull down on living standards over the medium-term. Against this backdrop, the policy response will of course be vital. Mark Carney has made it clear that the Bank of England stands ready to intervene to ensure financial stability. However, with the base rate already at just 0.5 per cent, the options available for supporting household incomes and stimulating demand are severely restricted. The alternative approach of raising rates in order to strengthen the pound would have disastrous effects for the incomes of stretched households – particularly given the continued overhang of household debt built up before the financial crisis – and therefore is likely to be off the table. For his part, the Chancellor has ruled out any fiscal response ahead of the Autumn Statement. While his pre-referendum focus was on the likely need to engage in more fiscal tightening in the event of a Brexit vote, the likely impact on household incomes in the coming months and the limited monetary headroom means that such an approach would not be appropriate in the near-term. At the very least the automatic stabilisers should be allowed to kick in and the efficacy of planned cuts to working-age benefits will need reconsidering. While the precise relationship between incomes, inequality and the apparent disillusionment with the status quo that characterised much of the referendum debate needs to better understood, it is clear that the coming months will pose new challenges that cannot be ignored. Our relationship with Europe will inevitably dominate political discussion for some time to come, but we cannot afford to let that detract attention from supporting living standards within our society.