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Inflation after Brexit set to wipe out two years of pay rises

Economists see inflation accelerating above 3 per cent next year, eroding the spending power of British households

Thursday 25 August 2016 09:04 BST

Consumers spending has been strong but price rises caused by a weak pound are set to bite, say economists (Reuters)

Quickening inflation looks set to erode almost two years of real-wage growth, undermining the key driver of the economy.

Data due on Friday will probably show consumption helped growth accelerate to 0.6 per cent in the second quarter, before the referendum on European Union membership.

Still, there are challenges ahead for households. The pound’s 11 per cent drop since the 23 June vote is already pushing up the price of imports and some economists see inflation accelerating above 3 per cent next year, eroding the spending power of British households.

Businesses may already be feeling the Brexit effect, with economists predicting firms scaled back spending last quarter.

Bank of England projections for inflation to reach 1.9 per cent next year leave real-wage growth at about 1 per cent in the fourth quarter of 2017, down from as much as 3.2 per cent last year.

(Bloomberg (Bloomberg)

If the more aggressive inflation forecasts of the National Institute of Economic and Social Research prove correct, real pay may turn negative for the first time since 2014.

“Consumer spending and investment are the clear losers” in the post-Brexit environment, said George Buckley, chief UK economist at Deutsche Bank. “Higher inflation will erode purchasing power, and if you’re worried about your job, the likelihood is that you’ll start to save more. Plus there will probably be a rise in unemployment.”

(Bloomberg (Bloomberg)

While retail sales had their best July for 14 years, official figures may not yet be capturing consumer anxiety, Buckley said. ONS Chief Economists Joe Grice has cautioned that it’s too early to know the precise impact of the referendum on economic activity.

The Bank of England slashed its 2017 growth forecast to just 0.8 per cent from 2.3 per cent on 4 August and predicted unemployment will reach almost 6 per cent by 2018.

6 ways Britain leaving the EU will affect you

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1/66 ways Britain leaving the EU will affect you

6 ways Britain leaving the EU will affect you

More expensive foreign holidays

The first practical effect of a vote to Leave is that the pound will be worth less abroad, meaning foreign holidays will cost us more

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6 ways Britain leaving the EU will affect you

No immediate change in immigration status

The Prime Minister will have to address other immediate concerns. He is likely to reassure nationals of other EU countries living in the UK that their status is unchanged. That is what the Leave campaign has said, so, even after the Brexit negotiations are complete, those who are already in the UK would be allowed to stay

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6 ways Britain leaving the EU will affect you

Higher inflation

A lower pound means that imports would become more expensive. This is likely to mean the return of inflation – a phenomenon with which many of us are unfamiliar because prices have been stable for so long, rising at no more than about 2 per cent a year. The effect may probably not be particularly noticeable in the first few months. At first price rises would be confined to imported goods – food and clothes being the most obvious – but inflation has a tendency to spread and to gain its own momentum

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6 ways Britain leaving the EU will affect you

Interest rates might rise

The trouble with inflation is that the Bank of England has a legal obligation to keep it as close to 2 per cent a year as possible. If a fall in the pound threatens to push prices up faster than this, the Bank will raise interest rates. This acts against inflation in three ways. First, it makes the pound more attractive, because deposits in pounds will earn higher interest. Second, it reduces demand by putting up the cost of borrowing, and especially by taking larger mortgage payments out of the economy. Third, it makes it more expensive for businesses to borrow to expand output

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6 ways Britain leaving the EU will affect you

Did somebody say recession?

Mr Carney, the Treasury and a range of international economists have warned about this. Many Leave voters appear not to have believed them, or to think that they are exaggerating small, long-term effects. But there is no doubt that the Leave vote is a negative shock to the economy. This is because it changes expectations about the economy’s future performance. Even though Britain is not actually be leaving the EU for at least two years, companies and investors will start to move money out of Britain, or to scale back plans for expansion, because they are less confident about what would happen after 2018

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6 ways Britain leaving the EU will affect you

And we wouldn’t even get our money back

All this will be happening while the Prime Minister, whoever he or she is, is negotiating the terms of our future access to the EU single market. In the meantime, our trade with the EU would be unaffected, except that companies elsewhere in the EU may be less interested in buying from us or selling to us, expecting tariff barriers to go up in two years’ time. Whoever the Chancellor is, he or she may feel the need to bring in a new Budget

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Officials reduced their benchmark interest rate to 0.25 per cent in August and a majority expect another reduction if the data deteriorates in line with their central forecast.

“The household sector has been holding up pretty well for now,” said Chris Hare, an economist at Investec.

“There are two things we see happening: businesses will invest less and hire fewer people, which is bad for households, and also higher inflation, given the fall in the pound, will weigh on real take-home pay.”

Bloomberg

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