Marketing No Comments

Carney warns MPs of economic problems

The economy would face an unprecedented series of problems if the UK leaves the EU without a deal, Bank of England governor Mark Carney has told MPs.

Speaking before the Treasury select committee this morning (November 20), Mr Carney and his colleague, bank chief economist Andy Haldane, said the UK’s departure was an event that has no recent precedent in economy history, as the supply and demand sides of the economy would shrink at the same time under a no-deal.

Traditionally, recessions are caused by one or the other of those events happening in the first instance.

This means either the level of total demand falls in an economy and companies react by cutting jobs, which causes a further reduction in demand until demand and supply are in equilibrium.

Or the supply of goods and services expands at a rate faster than demand, which leads to much higher inflation, and higher interest rates until the supply of money becomes constrained. This leads to businesses with a lot of debt cutting staff, and supply falls into line with demand.

Policy makers traditionally know how to deal with either of those separate scenarios, but the bank is expecting a rare event where both the supply and demand sides of the economy shrink at the same time.

This would happen, according to the Bank, because the demand for goods and services would fall as companies and consumers reduce spending in anticipation of a recession, while the supply of goods and services would shrink because tariffs on imports from the EU would make the UK a less attractive market for overseas firms. Restrictions on immigration would also mean the supply of labour falls.

The result would be sharply higher inflation happening at the same time as a sharp fall in demand, a scenario economists call “stagflation”.

Typically central banks can deal with the problem of lack of demand, or lack of supply, through interest rate policy, but if both happen at once the problem is more difficult.

Mr Carney was reluctant to reveal whether he would favour putting interest rates up, or cutting them, if the UK leaves the European Union (EU) without a deal.

Higher interest rates would strengthen sterling and address the supply side problems. But they would push borrowing costs up for consumers and companies and so reduce demand further. Cutting interest rates might help consumer spending but would create more inflation.

Hinesh Patel, portfolio manager at Quilter Investors, said: “A tumultuous departure would leave the Bank in the impossible position of trying to manage the risk of rising imported inflation if the pound were to fall further, while also trying to create conditions that are supportive of growth through a difficult period for the economy.

“The Bank has been really clear and consistent in pointing out its view that Brexit uncertainty has stunted business investment, a key driver of growth. Therefore in the event of a disorderly Brexit, Carney and his colleagues would likely anticipate a further shrinkage in business investment and would be tempted to respond with stimulus, but that in turn makes it difficult for them to keep inflation down.”

Mr Carney has previously stated one measure he would use in the event of a no deal Brexit would be to loosen the restrictions on commercial bank lending. He said this could inject £300bn into the economy. That could help boost demand in the economy, by making money cheaper and easier to borrow, but would also contribute to inflation.

Ed Smith, head of asset allocation research at Rathbones said sterling’s value may already be pricing a no deal Brexit, and so may not drop much further if, what he perceives to be the most disruptive outcome, were to happen.

Edward Park, deputy chief investment officer at Brooks Macdonald, said the supply and demand constraints highlighted by Mr Carney were already evident in the economy.

He said: “The UK earnings season has again shown the precarious state of the UK retail market which has struggled to pass on cost pressures to consumers. Exporters who are wrestling with the practicalities of European distribution in the event of a no deal have delayed investment and this has contributed to suppressed earnings expectations for 2019.”

Jeremy Lawson, an economist at Standard Life Aberdeen, said the reason most economists were wrong about the impact of Brexit on the UK economy in the aftermath of the referendum was that a supply shock happened, rather than a demand shock, and this led to higher inflation but was not such a shock that it caused a recession.

Source: FT Adviser