Brexit uncertainty and global trade tensions are hitting UK growth, with the Bank of England’s forecasts showing a one-in-three chance that the economy will shrink at the start of next year.

In its August inflation report, the bank cut its central forecast for growth this year and next, predicting output will expand just 1.3 per cent in both 2019 and 2020 even if it were to cut interest rates as markets have been expecting. The BoE had previously forecast in May that output would grow by 1.5 per cent and 1.6 per cent respectively.

It added there was a 33 per cent probability of negative growth in the first quarter of 2020 if interest rates remained unchanged — the highest chance of a contraction it has seen since the immediate aftermath of the Brexit referendum in August 2016.

Even after taking account of the volatility caused by Brexit-related stockpiling and factory shutdowns, “underlying growth appears to have slowed since 2018 to a rate below potential,” the Monetary Policy Committee judged, noting that weaker global growth and entrenched uncertainty over the Brexit process were weighing on companies’ spending. Its nine members voted unanimously to leave interest rates on hold at 0.75 per cent.

In contrast with the BoE, investors are factoring in an increasing risk of a disruptive Brexit, and they have assumed that policymakers would respond to this by cutting interest rates. Both this, and the recent sharp depreciation in sterling, result in a higher forecast for inflation.

The BoE has declined to set out any alternative forecasts based on a less benign outcome, because it feels bound to reflect official government policy that the UK will strike a deal with Brussels.

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The MPC signalled that interest rates would still be likely to rise after any Brexit deal that resolved these uncertainties, to keep inflation at its 2 per cent target.

The BoE’s central forecasts, which are premised on a smooth Brexit that would boost the economy, show inflation overshooting its target by a significant margin, rising to 2.4 per cent on a three-year horizon. The forecasts also show a strong rebound in growth, which rises to 2.3 per cent in 2021 — above the May forecast.

But the bank acknowledged that these forecasts were of little practical use at present, since they are built on the prevailing market exchange rate and on market expectations of the path of interest rates.

It has not made any change this month to reflect the increased likelihood of a no-deal exit from the EU after last week’s appointment of Boris Johnson as prime minister.

Since Mr Johnson entered Downing Street, he has instructed ministers and officials to “turbocharge” no-deal preparations and on Thursday the chancellor Sajid Javid announced £2.1bn in extra funding to prepare for the UK crashing out of the EU on October 31.

The MPC still maintains that interest rates could move in either direction after a no-deal Brexit, even though several of its members have said that they believe a rate cut would be the likely outcome.

Instead, the August inflation report includes alternative projections showing what would happen if a Brexit deal led markets to take a more optimistic view of the economic outlook.

Even in these scenarios, it suggests that interest rates would need to rise to keep inflation on target.

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Assuming a 5 per cent rise in the trade-weighted value of sterling, and a quarter-point increase in interest rates in the next three years, inflation would be just above target at 2.1 per cent by the third quarter of 2022, the projections show.

With a 10 per cent rise in trade-weighted sterling, and two quarter point increases in interest rates, inflation would be below target at 1.8 per cent but much of this would be due to the temporary effect of a strong pound on import prices, and the BoE believes excess demand would still be stoking domestic inflationary pressures.

Although GDP growth and inflation would be lower in these scenarios, the BoE said: “There is still significant excess demand at the end of the forecast period, which would boost inflation beyond that point.”

Via Financial Times