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Bank of England keeps rates on hold despite Brexit

14-07-2016 | Insight | Léon Cornelissen The Bank of England surprised investors by keeping its base rate unchanged at 0.5%, despite expectations for a cut following the Brexit vote.

Speed read:
  • UK central bank keeps rates unchanged as it awaits further data
  • First stimulus likely after August publication of Brexit effects
  • New PM appoints Brexiteers to key government posts
Theresa MayThe UK central bank’s Monetary Policy Committee (MPC) chaired by Governor Mark Carney voted 8-1 not to slash the repo rate in half to 0.25% in what would have been the first rate change since 2009. The decision to wait for further economic developments came the day after Theresa May took office as UK Prime Minister following the resignation of David Cameron.

The British pound rose in value against the euro and US dollar, while the Eurostoxx50 index and the UK’s FTSE 100 Index sold off after having risen by more than 1% anticipating a rate cut. The yield on the 10-year British Gilt tightened by 4 basis points to 76 basis points.

“It’s a surprise because Carney had earlier said that he anticipated looser monetary policy to be needed to cushion the economy over the summer,” says Robeco Chief Economist Léon Cornelissen. “Still, the MPC has now strongly signaled that a rate cut and more quantitative easing in August is more likely following the publication of its new economic forecasts.”

‘Such a modest rate cut wouldn’t prevent a UK recession’

“Interest rates are already at an historical low, and the Bank has said that it is not comfortable with negative rates, so its room for maneuver is limited. It can now easily refrain from action by saying it needs more economic data.”

“Nevertheless, markets had anticipated a modest pre-emptive strike, but while probably also realizing that such a modest rate cut wouldn’t prevent a UK recession that may well come because of the Brexit decision.”

“In the meantime, the future relationship between the UK and the EU remains uncertain, and this will dampen investment. There will be rising import inflation as a consequence of the weak pound, which will lower consumer spending.”

August Inflation report

The central bank’s action follows the historic referendum on 23 June in which 52% of Britons voted to leave the European Union. The Bank will publish its quarterly Inflation Report on 4 August, with new forecasts for growth and inflation including its first estimates of Brexit effects.

The new UK government under Theresa May must still trigger Article 50 of the Lisbon Treaty in order to start the Brexit process. May, who had campaigned for the UK to remain in the EU, has already put pro-Brexit ministers into important government roles, including the surprise inclusion of former London Mayor Boris Johnson as Foreign Secretary. She created two new Cabinet posts to deal with the Brexit’s aftermath: Secretary of State for Exiting the European Union, already dubbed ‘SEE U’ by critics, and Secretary of State for International Trade, who will negotiate new trade deals once the UK leaves the European Single Market.

“The new prime minister has appointed Brexiteers into important government posts to handle divorce negotiations with the EU, but the strategy is still unclear,” says Cornelissen. “The government will have to choose between the free movement of labor and getting full access to the Single Market, and that won’t be easy.”

Limiting Johnson’s power

“The frivolous goodbye of Cameron and the appointment of Johnson as foreign secretary has provoked sharply negative reactions in Europe. It is important to keep in mind that Johnson’s power will be limited and negotiations will be handled by the new SEE U secretary, David Davis. Power has drifted from the Foreign Office to the PM and the new Chancellor of the Exchequer, Philip Hammond. So in a way, Johnson has been neutralized, which will probably be welcomed by many.”

Hammond, who like May had campaigned to remain in the EU, has already ruled out a ‘Brexit Budget’ after his predecessor warned of an emergency package of measures if the UK voted to leave. Meanwhile, it is important to remember that the Brexit has not yet occurred, Cornelissen says.

‘The UK is in limbo and will suffer as a result’

“Theresa May saying that ‘Brexit means Brexit’ is basically meaningless unless Article 50 is invoked.,” he says “And it’s not likely to be invoked until the end of this year, or early next year, and maybe even later or not at all. The UK is in limbo and producer and consumer confidence will suffer as a consequence.”

“There is also talk of a general election to get a mandate for the new PM’s administration, but the longer it takes to hold one, the more likely it is that the UK economy will drift into a recession, and that makes holding an election more and more unpalatable.”

Attention turns to Italy

Cornelissen says attention will now turn towards Europe, particularly in Italy where Italian Prime Minister Matteo Renzi has called a referendum on constitutional reform to take place in October or November. The reforms aim to stabilize the Italian political system but is already being seen by some as another referendum on EU membership. Renzi’s bigger local problem is stabilizing Italian banks which are overloaded with bad debts.

“The main Brexit-related fear is that it will embolden euro-skeptic parties all over the EU, but of course the ongoing political and economic chaos in the UK can also have a contrary effect by demonstrating that it’s not worth it,” says Cornelissen.

‘Renzi’s demise would threaten the integrity of the Eurozone’

“The first test will be the referendum on constitutional reform in Italy: Renzi has announced he will resign if he loses. He’s now running into political difficulties because of the Italian banking crisis which has been exacerbated by the Brexit vote. New European rules in principle would necessitate a bail-in of Italian bank bondholders. However, subordinated debt has been sold to Italian households, so a bail-in is a political impossibility.”

“We feel that a compromise is possible at the European level to prevent such a dilemma and help Renzi, as major European politicians are fully aware that his demise would threaten the integrity of the Eurozone and cause another crisis.”

Léon Cornelissen

Léon Cornelissen

Chief Economist
"You can be sure of risk, you can’t be sure of return."
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