Growth amount hinges on Brexit outcome being soft as possible
The economy grew by 0.5% and 0.4% in the final two quarters of 2017, regaining some momentum after a weak first half to the year.
However, when one compares the UK’s performance to other economies, the impact of the Brexit vote is clear to be seen.
Ahead of the vote, the UK was the strongest growing G7 economy. By the end of last year, the UK had fallen to the bottom of the table to become the slowest growing G7 economy.
Its year-on-year growth rate had decelerated to 1.4% by the final quarter of 2017, below that of Italy and Japan.
Indeed, the UK is the only major world economy that has experienced a slowdown in growth in the past couple of years.
The slowdown would have been even more pronounced but for the improvement in the global economic environment and weakening of sterling, which has helped exporters. This is most obvious in the improved performance of the UK manufacturing sector.
The slowdown in the UK economy has been accompanied by a deceleration in the pace of employment growth.
However, the unemployment rate has fallen further to below 4.5%, owing to the fact that there has been a marked fall-off in inward migration and, thus, labour force growth since the referendum vote.
The tightening labour market and better-than-expected growth performance of the economy has reduced the Bank of England’s tolerance for the marked acceleration in UK inflation to 3%, driven by a sharp rise in import prices as a result of sterling’s sharp fall.
The expectation, last summer, was that UK rates would remain largely unchanged until 2020. However, the Bank of England increased rates by 25 basis points to 0.5% in November to dampen inflationary pressures.
At its policy meeting earlier this month, the bank hinted that further rate hikes would be required. It said it was appropriate that monetary policy be altered to return inflation back to its target within a shorter time horizon than it had previously envisaged.
While BoE gave no indication that a rate hike was imminent, it explicitly stated that rates would need to rise “somewhat earlier and by a somewhat greater degree” than it had envisaged at the time of the November rate hike.
There has been a marked firming of rate hike expectations in the UK in the aftermath of the BoE meeting. The market is envisaging around 100 basis points in rate increases between now and the end of 2020.
From a timing perspective, futures contracts are suggesting the next rate increase could come as early as May, with a further hike likely at the end of the year, taking rates up to 1%.
Two further hikes are priced in over the course of 2019 and 2020, which would bring rates up to 1.5%.
The series of rate hikes now being priced in by markets suggests they believe there will be a ‘soft’ Brexit in March 2019 that will not have a significant negative impact on the economy. BoE is now forecasting solid UK growth of 1.75% over the next couple of years.
This combination of expectations for higher UK interest rates and a soft Brexit has seen sterling strengthen since last summer.
If both are delivered on, then sterling should make further gains.
