UK unlikely to change interest rates until Brexit decision

UK unlikely to change interest rates until Brexit decision

The rate hike cycle that appears to have started in the U.S. is not likely to cross the Atlantic anytime soon.

In its first policy meeting of 2016, the Bank of England (BoE) kept interest rates unchanged at 0.5%. The vote by the Monetary Policy Committee (MPC) was nearly unanimous, with only one of the nine members in favour of an immediate 25 basis point hike, according to the minutes of the meeting.

The fact that interest rates remain at near-zero levels suggests that the BoE is not yet fully confident about the country’s growth and inflation prospects to move interest rates away from levels that are the lowest in the Bank’s 300-year history.

For most of 2015, inflation in the U.K. hovered around zero – below the Bank’s target of 2%. This may have been because of the slump in oil prices, but the minutes of the meeting stated that core inflation – which excludes food and energy products – is still low. Core inflation is the preferred inflation measure of policymakers who believe it is a better indicator of long-term inflation.


Source: Office for National Statistics

There is a danger that such low inflation rates may turn negative. This can depress growth as falling prices induce consumers to postpone purchases – a situation that Japan experienced for many years.

According to economic theory, a rise in interest rates tends to drag down inflation, so this may be one reason why the BoE prefers to wait before embarking on a rate hike cycle.

The Bank expects inflation rates to increase later in the year, when the impact of last year’s declines in food and energy prices is eliminated. Even then, the Bank may not hike rates, as there may be some risks to domestic growth.

In its latest Global Economic Prospects report, the World Bank reduced its forecast for the U.K.’s growth rate in 2016 to 2.4% from an earlier estimate of 2.6%. The minutes expressed concern about possible spillover effects of sluggish growth in emerging markets. These countries may suffer as interest rates in the U.S. trend higher, which could have ripple effects for developed countries.

Factors nearer to home also have the potential to drag down growth, such as the prospect of a Brexit. Opinion is divided on whether or not the country will be better off outside the bloc. If the U.K. does decide to leave, then it may find it more expensive to export goods to the European Union, which could drag down growth. The E.U. is larger than any single economy and is a major trading partner as the chart below shows.


Source: Office of National Statistics

It is likely that even if the U.K. does leave the E.U., it could negotiate a separate free trade agreement. However, these negotiations may not occur immediately. There is also no precedent as no other country has left the E.U. (in its current form) before.

In the short-term, there may be a lot of ambiguity, which may drag down U.K. growth. Furthermore, if the U.K. does vote to leave the E.U., then there could be a second referendum on Scottish independence, as suggested by the First Minister of Scotland in an interview last year.

The prospect of these uncertainties may itself cause companies to postpone expansion, which may adversely affect growth and push inflation lower. On the other hand, inflation may increase if the pound depreciates because of the uncertainty. But even in this case, inflation is unlikely to significantly exceed the 2% threshold, because of subdued oil prices and the absence of domestic wage growth.

It is likely that rates will remain on hold at least until the question of E.U. membership is resolved. Even when rates do rise, they are likely to do so only gradually, according to the minutes. The pace of rate hikes in both the U.K. and the U.S. is likely to be slower than in previous rate hike cycles.

In conclusion, it seems likely that there will be three lanes of monetary policy in the developed world in the near-term.

Currently, the Fed is in the rate hike lane, while the ECB and the Bank of Japan have taken the path of loose monetary policy. These central banks are likely to retain (or possibly expand) their stimulus programmes and keep rates low. The BoE is likely to follow the middle lane of no change for now.

Categories: Economics, Europe

About Author

Nandini Rao

Nandini has a Masters in Financial Economics from Saïd Business School, University of Oxford and a BSc (Honours) in Economics from Aston University. She focuses on monetary policy.