The chancellor on Monday morning sought to reassure the markets with a hastily arranged press conference a few hours after dawn. Of course, the very fact that the chancellor felt the need to take this step is itself far from reassuring. George Osborne’s message was drawn from the same script as that of Bank of England governor Mark Carney last Friday – the fundamentals of the UK economy are sound and the financial system is healthy. The issue is that the fundamentals are no longer really sound.
Markets have continued to be volatile in the immediate aftermath of the referendum result. Share prices are down (although some exporters are doing well), the pound has hit a fresh 31-year low against the dollar, and the cost of government borrowing has fallen to a record low as investors seek safety in supposedly ultra-safe assets such as UK government bonds.
The problem is that for all his soothing words, Osborne is not capable of giving the markets or the wider real economy what they need: a clear picture of what happens next. Uncertainty is what is causing markets to gyrate, which is already starting to do real damage to the economy.
No one knows whether the UK will have access to the single market in the future, whether UK firms will face tariffs on their exports, or what immigration policy will look like in a few years’ time. Political authority has drained from a lame-duck government that has stated that the post-Brexit negotiations will be handled by its successor, and none of those potential successors have yet spelled out anything approaching a realistic vision.
Until a firm plan is on the table, extreme uncertainty will reign. And even once a firm plan is on the table, until a deal is actually struck uncertainty will remain elevated. Against this backdrop, firms are likely to respond by delaying or cancelling their investment plans. In the medium term, it isn’t wild swings in the markets that will do the real economic damage, it is firms putting a stop to their spending and hiring plans.
As investment plans are put on ice, we are likely to see some secondary effects. Consumers worried about the future could start to delay their own purchases and increase their precautionary savings. Economic demand will slow as private sector spending slows, which itself may force even domestically focused businesses to cut their own expansion plans.
The fall in the value of sterling will push up the cost of imported goods – such as food and energy – adding to a squeeze on consumer spending. Exporters may get a boost from a lower pound, but with many UK exports either being part of a complex global supply chain or selling goods and services that are not especially price-sensitive, then that boost will be unable to offset the weakness. In short – in the absence of a policy response – economic growth will slow sharply in the months ahead. A shallow recession is a distinct possibility. Until uncertainty recedes it is very hard to see strong growth in either business or household spending.
One concern is that policy will not respond as quickly as it could. The chancellor made clear that fiscal policy (the level of government spending and taxation) will not be reassessed until the autumn. In other words, there will be no immediate stimulus plan from the Treasury, and the Bank of England will have to face this slowdown alone.
Faced with a hit to economic demand, the textbook monetary policy response is to ease policy – cut interest rates further, do more quantitative easing or take steps to ease up bank lending. The problem is that the UK is not just facing what economists call a demand-side problem (the hit to spending) but also a simultaneous blow to the supply side of the economy affecting its ability to produce economic output in the future.
A corporate investment strike could well lead the Bank of England to believe that inflation may be a problem in the future, limiting its room to ease policy now. In straightforward terms, the bank may not be able to ease policy as much as it would like from the point of view of protecting growth.
In short, the economic fundamentals have changed since Thursday. For the next few months the outlook is far grimmer than it was. The central scenario now is for a sharp slowing of growth – regardless of what Osborne says or does. The downside risk is that foreign investors begin to lose confidence in the UK and the record inflows of foreign capital we have seen begin to dry up. If that happens, then that central scenario will begin to look optimistic.