Macroeconomic policy The Bank has acted, but the real drama is yet to come 4 August 2016 by Matthew Whittaker Matthew Whittaker While the time since the UK voted to leave the EU can still be measured in weeks rather than months, evidence is starting to come in on the extent to which that decision is impacting on the economy. It will be a while longer before we get hard data on output, but the picture painted in the Purchasing Managers’ Index surveys – with apparently sharp deteriorations across the services, manufacturing and construction sectors – points to a gloomy near-term outlook. Given this evidence, it’s not surprising that the Monetary Policy Committee acted today to cut interest rates to an historic low of 0.25 per cent. While welcome, this reduction is small relative to the usual monetary loosening cycle entered into by the Bank. Since 1975, such cycles have cut rates by an average of 5 percentage points: the proximity to the zero lower bound (and the Bank’s reluctance to move into negative interest rate territory) precludes action of this scale on interest rates this time around. With this in mind, we must hope that the wider package announced by Mark Carney – including a new £100 billion Term Funding Scheme (designed to ensure that banks pass the rate cut onto firms and households), a £60 billion increase in Quantitative Easing and the purchase of up to £10 billion of corporate bonds – proves effective in stimulating additional demand. The nature of such unconventional monetary policy is that it is hard to second guess its impact ahead of time, meaning that the MPC will need to keep a careful eye on developments once the harder data starts to come in. But, notwithstanding this action, the reality is that the Bank can only do so much. On the severe near-term economic cooling associated with the post-referendum uncertainty, the Bank can help. But longer-term, our economic performance rests on the post-Brexit picture on trade, competition and – crucially – productivity. Influencing those outcomes largely rests with Downing, not Threadneedle, Street. It’s that reality which explains why the Bank today downgraded its forecasts for growth, employment, pay and incomes through to 2018, even after accounting for its package of policy action. In the charts below, we pick through these revisions to highlight the Bank’s assessment of the medium-term consequences of the referendum. Of course they represent even more uncertain projections than usual, given how little we currently know about the UK’s relationship with the rest of the world. And they offer just one – albeit expert and important – perspective (we’ve written before on the range of outlooks offered by independent forecasters). But the scale of the revisions since the May Inflation Report highlight the significant challenge facing families on living standards and our policymakers in responding. Looking first at the overall economic picture, today’s figures imply markedly slower GDP growth in the next two years. The result is an economy in 2018 that is around £45 billion smaller than the Bank thought would be the case back in May. This has implications for all of us and will be a particular cause for concern for Philip Hammond as he prepares his first Autumn Statement later this year. Inflation will of course be affected by the sharp falls in the value of the pound since 23 June. Imports – both final and intermediate goods – have become more expensive, implying a straight feed through to prices. By loosening rather than tightening today, the MPC has acknowledged that it is more important to deal with near-term demand deficiency than pulling back on inflation – an approach that makes sense with a temporary inflation pressure while inflation expectations remain anchored. The upshot is that the Bank expects the price level (as measured by CPI) to be 1.1 percentage points higher in 2018 than it previously projected, with obvious implications for living standards. Even before taking account of this increase in inflation, the Bank has reduced its projections for nominal average earnings growth. The cumulative reduction of 1.6 percentage points in 2018 is equivalent to around £380 a year per worker. Combining these two factors – higher inflation and slower nominal pay growth – produces a significant reduction in projections for real-terms average earnings growth. As the next chart shows, the Bank’s August figures imply pay being around £615 a year lower in real terms in 2018 than it thought in May. Of course, living standards depend not just on pay, but on employment too. In absolute terms, the latest numbers imply 320,000 fewer people in work in 2018 than had previously been thought. In practice, some of that decrease is likely to relate to lower levels of immigration (that is, the working-age population will be smaller). But the Bank has also increased its projection for the unemployment rate (from 4.9 per cent in 2018 in the May report to 5.6 per cent in today’s), indicating additional slack in the labour market. Taking these various factors together, the new Inflation Report implies that average household income growth – after tax and in real-terms – will be significantly lower than previously thought. By 2018, households are set to be roughly £680 a year worse off on average than was implied by the May projections. Today’s package of action from the Bank of England is designed to offer some support for an economy that appears to have had its confidence shaken in the light of the vote for Brexit. Given the unconventional nature of much of that package and the proximity to the lower bound on interest rates, it remains to be seen just how effective it will be in that task. But what’s beyond doubt is that our longer-term outlook will owe far more to the actions of Theresa May and her new government over the coming months and years.