Sterling has fallen sharply because of that vote: against the euro it is 7.2 per cent below its pre-referendum level as I write, and against the US dollar it is down by 9.4 per cent. This is much as expected: the Bank of England warned in May that “sterling is also likely to depreciate further, perhaps sharply,” in the event of a Brexit vote.
These falls will raise inflation. The impact, however, will not be massive. One reason for this is that many firms “price to market”. Some overseas exporters will hold prices down in an effort to stay competitive with UK producers. It’s for this reason that, since the late 90s, each one per cent move in sterling’s trade-weighted index has been associated with only a half per cent move in import prices. The impact of sterling’s fall will therefore be borne in part by overseas firms suffering lower profit margins: this is one reason why euro area share prices have fallen even more than UK ones.
The impact on inflation will be further dampened by domestic wholesalers and retailers’ taking a squeeze on margins: it’s no accident that general retailers’ share prices were especially hard-hit last Friday.
One simple fact shows that sterling doesn’t have massive effects upon inflation. It’s that since 1999 the CPI inflation rate has only been one-fifth as volatile as annual changes in the trade-weighted index. This tells us that the impact of the latter gets largely smoothed out.
Nevertheless, there will be some effect. Fabio Fois at Barclays expects CPI inflation to rise by a little more than one percentage point as a result of sterling’s fall. This comes on top of the fact that inflation was likely to increase anyway later this year as the effect of lower oil prices drop out of the data. He expects inflation to exceed two per cent by late 2017.
This does not, however, mean interest rates will rise. Quite the opposite. Mr Fois expects the Bank of England to cut Bank rate, perhaps in August. Martin Beck at the EY Item Club agrees. He says the Bank “is likely to look through a temporary rise in inflation and support the economy via a loosening of monetary policy”.
The reason for this lies in the same reason why sterling fell so much. Sterling fell because traders expect weaker economic activity. The Bank warned in May that Brexit would cause firms to “delay investment, lowering labour demand and causing unemployment to rise”. We’re already seeing signs of this. A survey by the Institute of Directors has found that 36% of its members will cut investment as a result of Thursday’s vote, whilst only 9% will increase it. This could well more than offset the stimulative effect of the weaker pound, especially as this is likely to be small.
All this points to negative real interest rates: a Bank rate of zero and inflation of two per cent is quite possible next year. This won’t be reversed quickly. The fact that gilt yields are so low tells us that rates are expected to stay low for a long time: this is because Brexit-related uncertainty has compounded the danger of secular stagnation.
In this sense, Brexit is bad news for savers.
