UK BOE Interest Rates On The Way Up

The Governor of the Bank of England, Mark Carney, finally announced the long promised decision to increase the UK BOE interest rate by a quarter of one percent. This brought the base rate back to the heady height of one half of one percent. In other words, back to the same level as the post-Brexit referendum rate of July 2016.

The Monetary Policy Committee voted 7-2 in favour of a rise, with 5 members shifting their positions from hold to raise.

The driving factors were a worse than expected inflation rise to 3%, and a better than expected quarterly growth rate figure of 0.4%. The consensus is that despite the uncertainties of Brexit, the UK economy is strong enough to withstand a small increase in the cost of borrowing.

Future Direction Of Interest Rates Is… Nowhere Fast

Meanwhile, the outlook for Brexit remains pessimistic with a possible “no deal” scenario. “No deal” would create major uncertainty for businesses dependent on European sales or supplies.

This uncertainty increases the internal rate of return on projects and hence both reduces and delays positive investment decisions. The increased risk also forces businesses to build contingency funds.

The Governor of the Bank of England indicated that one interest rise in 2018 and another in 2019 was on the cards which would take rates up to 1% by 2020.

It is possible however that a “no deal” Brexit may result in these presumed increases being deferred. Interest rates would revert to a quarter of a per cent or below if growth crumbles due to a poorly negotiated Brexit.

The market responded negatively to the prospect of little possibility of further significant interest rate rises by selling Sterling. This saw the Pound drop by 1.7% against the Euro and 1.4% against the US dollar. An increase in interest rates normally results in a strengthening currency. In this case it had the opposite effect, most likely because the increase was expected, was already priced into the current rate, and hence the weakening pound was due to the unexpected prospect of few further increases.

Will A No Deal Brexit Be That Bad?

A “no deal” Brexit is portrayed as a shambles with planes being grounded due to lack of agreement over air traffic control, Kent being turned into a giant lorry park due to customs delays at Calais, and a hard border being created between Northern Ireland and Eire to restrict movement of people, goods and services outside the EU.

In reality, some common sense would prevail and business would continue but, it has to be said, not as usual. There would be significantly higher costs due to the tariffs, delays and restrictions that would inevitably result from the lack of any agreement.

A Weaker Pound Is Good For Exports

In a “no deal” scenario I would expect the Pound to fall another 5 to 10%, inflation to push up to 5% driven by the projected double digit increase in some food costs.

Fortunately, it is not the same prospect for everyone. British exporters will find themselves at a competitive advantage so will prefer to sell to apparently affluent customers abroad than to a squeezed British consumer. “No deal” looks good for British exporters especially if their focus is outside Europe.

EU Dependent Supply Chains Under Strain

However, for British manufacturers with integrated supply chains across Europe it could be a nightmare as it will involve significant restructuring. The goal will be to minimise the number of times the product crosses EU borders during the manufacturing process. The goal will be to reduce the impact of the increased external costs through tariffs, internal costs through administration and delays through customs.

For some this may even entail moving the manufacturing process entirely inside or more probably outside the UK due to easier movement of skills, products and services.

New deals for trade will have to be cut with Europe. Though, in reality this will take 5 to 10 years to negotiate agreements that bring us even close to where we are now in terms of the efficiency of trading with Europe. Putting a two year restriction on any intermediate trade arrangement simply adds another cliff edge for UK trade to fall off in 2 years time. The agreements could simply be arranged at a market sector level and hence each could proceed at an appropriate pace to the needs of the particular sector. It should be driven by trade rather than politics for a better solution.

End Of Free Movement Of EU Workers Will Likely Increase Labour Costs

EU workers currently fill roles at all levels of employment: entrepreneurs, bankers, waiters, bartenders, nurses, doctors, agricultural labourers. Post Brexit, they will be subject to the same immigration rules as non EU workers.

The UK immigration system is made up of five tiers.

• Tier 1 – Investors
• Tier 2 – Skilled workers
• Tier 3 – Low skilled workers
• Tier 4 – Student visas
• Tier 5 – Temporary workers

The administrative cost of hiring and operating with migrant workers will increase for British businesses, as EU workers will now be subject to the additional checks

Low Skilled Worker Shortages

Specifically of interest low skilled workers, many of which are young EU citizens who’ve migrated to the UK under freedom of movement to gain experience and skills in a market less regulated than that in their home countries.

The Tier 3 category was designed to handle temporary labour shortages. The Government has so far never allocated visas under this scheme as EU workers filled these positions. Tier 3 is likely to be activated now to fill the gaps in the low skilled sector as recruiting UK citizens for these roles is likely to remain very difficult with current levels of unemployment.

EU Migrant Workers Replaced By Non EU Migrant Workers

These jobs will be filled by EU workers as before and also increasing from non EU countries. Why? Well, for social and economic reasons. A post Brexit UK is less friendly to EU workers and their savings in GBP will be worth less when converted back to Euro. EU workers will find the UK a less desirable place to work so fewer will want to come to the UK.

This is already evidenced by recruitment trends for the NHS. EU recruitment has plummeted in the last year and the NHS is now looking to recruit more doctors and nurses from Asia and Commonwealth countries rather than Europe in order to maintain staff levels.

At a national level net, EU migration will fall but non EU migration is likely to offset the drop. The government target of a figure of net migration in the tens of thousands is probably several years away if the economy continues to perform well and the economy keeps generating jobs to fill.

Impact Of No Deal Brexit On BOE Interest Rates

But what would be the impact on interest rates if there is a “no deal” Brexit?

The Pessimistic View: Another Ten Years of Austerity

One possible scenario would be a jump in inflation to above 5% driven by food and energy prices, labour shortages and a weakening economy. The BOE would see the economy as too fragile for a rise and hence it would lower rates and hence Sterling would fall.

A return to an interest rate of a quarter of one percent would be on the cards. A weakened Sterling would help exporters with the anticipated increase in tariffs being lost in the the exchange rate movement. For example, British farmers would look to sell more of their produce in Europe where they could achieve better prices than in the UK. The UK would collect less tax and public services would face further cuts. So in short, another ten years of austerity with the average UK worker being worse off each year as wage rises fail to match inflation. All very gloomy.

The Optimistic View: Gradual Recovery With Modest Growth

The alternative view is one where the UK operates under WTO rules with unilateral tariff free operations for critical markets such as food. This would allow the UK to access cheaper imports from around the world. British farmers would be left with facing tariffs when exporting to overseas markets however a weaker Sterling would offset this and hence selling their produce abroad would be preferable to dropping prices at home to compete with the cheaper foreign imports. With lower inflation, there is less pressure on interest rates and hence the single small quarter of one per cent rise each year is the most likely path.

Either way, ultra low interest rates are likely to be with us for another 5 years at least under a “no deal” Brexit.

Find out more on what operating under World Trade Organization rules would mean for UK businesses.