In contrast to economists, the central banking community do not share the same level of conviction that the UK will secure a deal on Brexit. Minutes from The Bank of England’s last MPC meeting in March (after the transition deal was revealed) strike a cautious tone:
Developments regarding the United Kingdom’s withdrawal from the European Union – and in particular the reaction of households, businesses and asset prices to them – remain the most significant influence on, and source of uncertainty about, the economic outlook.
This has been the BOE’s position since 2016. Besides Brexit, the bank has not identified any other immediate threats to the UK’s ‘recovery‘. Where further stress points do exist, such as with stagnant retail and a struggling construction industry, this has conveniently been placed under the umbrella of ‘Brexit related uncertainty‘. Record levels of consumer and public debt are also not considered a major threat (the BOE describe consumer debt as a ‘pocket of risk‘).
The International Monetary Fund have also been more guarded in their approach to a Brexit deal. Back in November 2017 they spoke of a ‘durable‘ recovery within the global economy, but warned that a ‘disruptive Brexit‘ would likely damage growth prospects in the UK and the Euro area. The IMF’s expectation at the time was that a transition deal would be reached, but they also revealed that they had not run any ‘no deal‘ forecasts in the event the UK failed to agree terms with the EU.
Two months later, IMF chief Christine Lagarde issued an open warning at the World Economic Forum in Davos that policy makers had become too complacent over economic growth:
While the near-term outlook is good, the mid-term outlook is more worrying, and a recession may be nearer than we think. The level of public debt means that the ammunition to fight another recession is not as strong as before, so world leaders must make sure to adopt the best policies now, and make hay while the sun shines.
Lagarde’s comments followed a more specific warning issued by the World Bank at the turn of the year. Author of the bank’s global economic prospects, Franziska Ohnsorge, said this:
There could be faster than expected inflation that would mean faster than expected interest rate hikes. Financial markets are vulnerable to unforeseen negative news. They appear to be complacent.
Three weeks later, markets around the world contracted sharply as worries over rising interest rates and inflation gained traction throughout the mainstream press.
You may be wondering at this point what connection these warnings have in regards to Brexit. In the wake of the referendum, the value of sterling fell by over 10%. To this day it has not recovered to pre-referendum levels. The reason this is significant is because the drop in sterling has been directly associated by the Bank of England as the cause for heightened inflation. In June 2016, inflation was at 0.4%. When the BOE raised interest rates in November 2017, inflation had risen to 3%.
As I documented in a series of blog posts on the Bank of England’s relationship to Brexit, the bank used rising inflation as a rationale to begin tightening monetary policy.
Today, Inflation has fallen to 2.7%. In response, the Bank of England put this down to the effects of sterling’s depreciation over the past eighteen months as having faded. They are now expecting ‘domestic cost pressures‘ such as rising wages to be a leading cause for inflation running over the bank’s 2% target over the next couple of years.
This tell us that if a deal between the UK and the EU is agreed, the logical reaction will be an increase in the value of sterling and the currency no longer being positioned as a threat for rising inflation. Part of the excuse for raising interest rates will have dissipated.
Are ‘domestic cost pressures‘ alone sufficient to, a) keep inflation above the bank’s target, and b), provide the BOE with justification ( in the minds of economists and the public) to continue tightening policy? I would suggest not. Whilst there is yet no definitive answer to this question, what there is evidence of is the long held preoccupation that central banks hold over one particular issue: protectionism.
Last month the Bank of England noted the following passage in their minutes from March’s MPC meeting, in relation to the threat of a global trade war:
A major increase in protectionism worldwide could have a significant impact on global growth and put upward pressure on global inflation.
Head of the Monetary and Economic Department at the Bank for International Settlements, Claudio Borio, expanded on this warning in an interview with Market News International last month:
Were the world to turn more protectionist, as the recent rhetoric suggests, there would be untoward implications for inflation too. In the short run, this would tend to raise prices and costs. And if a broader change in regime took place, giving labour and firms more pricing power and undoing some of the beneficial effects of globalisation, this could provide a more fertile ground for inflation.
Trade wars can have no winners, only losers.
In the same interview, Borio spoke of how ‘central banks have been overburdened for far too long‘ in regards to monetary accommodation over the past ten years. This is a narrative that Borio began cultivating in 2016, and is synonymous with the trend of bankers using communiqués as an extension of conventional monetary policy instruments.
Central bank communications have become a form of predictive programming, especially since the advent of Brexit and Donald Trump. Within mundane speeches and reports are often passages that illustrate the true character of their intent.
In summary, the coordination between the BIS and the BOE is clear: a rise in protectionism equals a prospective rise in global inflation. The trend currently at large throughout central banking has been to meet rising inflation with higher interest rates. This has not always been the case. The Bank of England allowed inflation to run above its 2% target between December 2009 and December 2013 without raising interest rates. The Federal Reserve also tolerated above target inflation between 2011 and 2012. The reasoning at the time was that the ‘global recovery‘ had not yet been secured. This is the same recovery that is predicated on central bank intervention. Low interest rates and stimulus measures were therefore maintained.
Now that political ‘populism‘ / ‘protectionism‘ has risen to the ascendancy, policy makers are rowing back on their support. Mathematically, this can only result in the eventual collapse of the debt bubble that central banks themselves have been responsible for re-inflating since the ‘Great Financial Crisis‘ of 2008.
It was Bank of England governor Mark Carney who described Brexit as ‘inflationary‘ in 2017. After the bank’s first rate hike in over ten years, Carney warned that in the event of a ‘bad deal‘, the BOE would be unable to respond by cutting interest rates due to the inflationary pressure it would cause. He also posited that the UK would suffer from higher inflation without a transition deal:
On the moment of Brexit, it will very much depend on what the final arrangement is with the EU 27 and what the transition path is from here to there. You could see a balance where [the effects on supply and demand] are inflationary and there not being that much spare capacity in the economy because capacity has been taken out.
What we have now is a prospective transition deal. It can only become active if a full agreement is reached between the UK and the EU.
The chart below, produced by Deutsche Bank, illustrates each stage of the Brexit withdrawal process. Note that any agreement must be sent to national parliaments in just five months time.
Businesses have entered the time period for implementing contingency plans for the possibility that a deal fails to materialise. The announcement of a transition deal was considered by many as a surprise, given that little progress was reported on beforehand. If businesses are now more confident of a deal, will they be as inclined to put as much effort into self preservation? Making contingency plans costs time, money and resources. Are they perhaps now more focused on making further investments and ignoring the dangers?
Ultimately, are they being lulled into thinking that neither the UK or the EU would allow a no deal to happen?
It has become increasingly evident that the Bank of England have used Brexit as a cover for beginning to reverse monetary policy, just as the Federal Reserve have used Donald Trump’s presidency as cover for a sustained course of interest rate hikes and the gradual reduction of its balance sheet.
The Bank of England present Brexit as the primary risk to financial stability. Whilst this could change over time, a successful deal would eliminate Brexit as a near term concern for the UK economy.
On the other hand, if central banks stay the course and persist with raising interest rates, they will require perpetual geopolitical struggle to act as justification for their actions – something which we are now witnessing.
Recent history demonstrates that interest rates in the U.S. were rising in the build up to the ‘dot com‘ bubble bursting in 2000, before being cut to levels consistent with the present. In the years preceding the subprime mortgage crisis and the fall of Lehman Brothers, rates were again on the rise. Policies emanating from central banks have the capacity to not just inflate a debt bubble, but also bring about its demise by way of a financial collapse. Consolidation of economic power into fewer hands is the result.
As I have written about previously, in an environment of no discernible unrest, the decisions of central banks today would be made into a vacuum, which risks a greater level of public scrutiny that would potentially leave them exposed as the culprits of a downturn.
A chaotic no deal on Brexit, marked by a precipitous fall in the value of sterling, would provide the Bank of England with the perfect rationale for continuing to tighten policy off the back of rising inflation. It would also allow for the UK’s unruly exit from the European Union to be presented as a cause for an ensuing economic decline, one which would likely manifest into a ‘Brexit Recession‘.