A broken record
12 December 2017
Brexit was the dominant issue in UK political and economic discourse over 2017. Expect more of the same next year. On the economic front, the onus will remain on both the short and longer-term impacts of leaving the European Union. Our base case assumes that growth will remain sluggish from a historical perspective, but broadly in line with the UK’s seemingly diminished potential. This combination is expected to lead to only a moderate pick-up in domestic wage growth and underlying inflationary pressures, with currency and commodity price effects exerting a larger influence on headline inflation rates. With regards to politics, the progress made last week clears the first major hurdle in Brexit negotiations, with the focus to turn to more complicated issues of the transition agreement needed to thrash out a new long-term trading relationship. We expect a successful agreement on a transition deal to pave the way for an eventual Free Trade Agreement, with imperfect Single Market access for goods and services trade, although this is expected to be a much bumpier and more drawn out process. Against this economic and political backdrop, the Bank of England is expected to raise rates just once over the year.
These views rest on a number of key assumptions. The first centres on the behaviour of businesses and households. On the former, we expect a still muted investment backdrop, with headline gross fixed capital formation expected to rise by just 1.1% over the year as a whole (see Chart 4). This development will of course be sensitive to progress made around a transition deal required to achieve stability for businesses after Article 50 expires. Household spending is similarly expected to remain subdued, largely reflecting a still-underwhelming outlook for real incomes. Critically, we do not see much scope for further declines in savings to support spending, with these already close to record lows and credit conditions seemingly tightening. Perhaps most important, and most uncertain, are assumptions around the supply side. We continue to expect potential growth to remain weak, reflecting both structural and cyclical drags on UK productivity. The risk here would be stronger investment, which could help provide a boost to labour productivity (with few signs that the deeper structural problems are being addressed). Finally, we don’t expect the tight labour market to lead to a significant uplift in domestic inflation (see Chart 5), with this Philips curve relationship having been weak in both the UK and other developed economies over a number of years. This should help the Bank feel comfortable with withdrawing policy only very gradually.
Our assumptions around the political backdrop represent continuity from what we have seen over the course of this year. Negotiations around the initial EU exit issues proved tense and bumpy, but eventually led to a breakthrough late in the year. This breakthrough was largely achieved through concessions from the UK, particularly around its financial obligations. This template looks likely to continue, with both sides negotiating hard but sharing enough incentives to achieve a deal which avoids the worst-case scenario of a fall back to WTO rules. These incentives are sharper on the UK side, given the disruption that the WTO scenario would cause to its economy, meaning that the onus will be on that side to make the greater concessions.