Tough times for the UK may force rate cut

The UK economy is struggling to stay above water. Brexit uncertainty has hit confidence, causing many companies to postpone or cancel investment projects.

Even households are now cutting back. According to the latest survey from the British Retail Consortium, average sales growth weakened to just 0.6% in the 12 months to June, which is the smallest rise since records began in 1995.

This morning’s GDP figures show the economy rebounded in May with 0.3% growth, but this was not enough to offset the 0.4% contraction in April. This suggests that there is still a significant chance that the economy shrank in the second quarter of the year.

The details of the GDP report help explain the problem. Industrial production (including manufacturing) picked up by 1.4%, but taking into account the 2.9% fall in April, the sector is still down on the quarter. Meanwhile, weakness in the manufacturing sector appears to be spreading. The services sector was flat in May, compared to just 0.1% growth in April.

It’s all about Brexit

In the run-up to the original 31 March Brexit deadline, companies and the government began to stockpile goods and supplies in anticipation of possible disruptions. With the latest Brexit deadline set for 31 October, companies have slowed production in order to manage the inventory overhang that we think remains large.

Whether the UK enjoys an orderly Brexit (with a deal) or not, the inventory build-up will eventually need to be run down, which suggests further weakness in economic growth. The timing is unclear as the governing Conservative Party is busy electing a new leader, while the opposition is attempting to legislate hurdles to block a no-deal Brexit.

Despite the final two candidates for prime minister both insisting that they will deliver Brexit in October, the reality is that there is not enough time to re-negotiate the current Withdrawal Agreement. Promises to “do or die” lack credibility. A delay seems inevitable.

Policy response?

The next prime minister is almost certain to loosen fiscal policy after years of austerity. Public spending as a share of GDP is at its lowest level since fiscal year 2003/04. Meanwhile, tax receipts are at their highest level since 1985/86. Tax cuts and some increase in spending are likely, but both will take time to have any meaningful impact on the economy.

Monetary policy would be more effective, but the Bank of England (BoE) seems reluctant so far to change course. The messaging from the BoE is that it is keen to raise interest rates to more normal levels, but is being held back by the high degree of uncertainty and risk that Brexit presents.

Our forecast has the BoE on hold this year, and one hike next year assuming an orderly Brexit. However, with downside risks to economic growth, the BoE has to be ready to quickly change its messaging and deliver interest rate cuts should the economy deteriorate further.