“A Bank of England rise in interest rates could add to the economic disaster of leaving the European Union”

Published in partnership with The Conversation:

The global economy is slowing. Most central banks are talking about cutting interest rates to boost the economic recovery. The US Federal Reserve has cut rates twice after consistently raising them in recent years. Markets are convinced that the only way for UK rates is down – a rate cut – if the UK experiences anything close to a “hard Brexit” transition.

But the Bank of England may defy market-watchers and other financial institutions, raising interest rates in the event of a No Deal Brexit. And that could add to the economic disaster of the crash-out of the European Union.

This would be disastrous and compound the negative impact on the British economy.

Before its meeting this month, the Bank’s Monetary Policy Committee offered a consistent, hold-the-line message. Its central projections for monetary policy were based on the assumption of a managed Brexit, with a stable relationship between the UK and its main trading partners. Under this scenario, rates would increase because the labor market and wage growth – arguably the vital indicator for the MPC – remained strong.

But on September 18, the MPC appeared to concede that the likelihood of No Deal had significantly increased. It recognized that the British economy “could follow a wide range of paths over coming years”. As a consequence, “the monetary policy response would not be automatic and could be in either direction”.

The official line was that rates might be cut or might be raised, but the image was of a Bank of England even more uncertain about the future than before.

Why Raise Rates?

The case for a rate cut is fairly simple. In the event of No Deal, the economy will slow. Trading with overseas partners will falter. Costs for domestic producers and even the service sector will rise almost immediately. Consumer spending, a key driver of the UK economy, will fall, driven partly by greater uncertainty and partly by rising living costs.

So a rate cut and more quantitative easing is potentially a mechanism for opening the flow of credit to firms and households.

However, the case for a rate hike may be equally compelling. No Deal Brexit will have a massive and immediate impact on the exchange rate, even worse than just after the June 2016 referendum. The cost of living will rise dramatically. In 2016, the Bank chose to weather the storm and rightly assumed that inflation would fall in the medium term. This time might be different.

The key difference in Wednesday’s MPC, suggesting that the Bank is inclined to raise rates, is the emphasis on government spending. Central banks across advanced economies have recently highlighted the limitations of monetary policy to promote a sustained economic recovery. Instead, they argue, any upturn depends on greater fiscal stimulus. Based on the evidence of Donald Trump and UK Prime Minister Boris Johnson, it seems that politicians have been paying attention.

In the UK, the Johnson Government’s spending package could be a decisive factor in the Bank’s future moves. Thus — whether the Conservatives have done their maths correctly, or whether Johnson manages to deliver — the significance of the MPC’s mention of the government’s proposals.

In recent years, the Bank has consistently argued that it would probably prioritize the fight against inflation over the pursuit of economic recovery. The conditions that allowed the US Federal Reserve to cut rates do not apply in the UK. And the severity of the fallout from a No Deal Brexit will require – at least in Bank minds– a rate hike.

Compounding Stagnation

But this would be disastrous for the UK economy. Not only would a hike compound economic stagnation, but the burden would fall on those already reeling from Brexit uncertainty: numerous studies have shown the impact of even small increases in interest rates on the most heavily indebted middle-income earners in the UK.

Then there is the whiplash effect on financial markets, given that they are convinced that a rate cut is a foregone conclusion. This might even lead to a run on sterling, which could force the Bank and Treasury intervene to defend the currency for the first time since 1992. There is even some evidence that the Bank has been bolstering its foreign currency reserves sine early 2016 to prepare for such a scenario

Given the dilemma the Bank is facing, perhaps the best for which we can hope is that the Bank again weathers the storm, as in 2016, and holds rates in the event of No Deal Brexit.

But that hope comes with a rider: do not rule out the unexpected.