A no-deal Brexit could result in a prolonged period with interest rates at a record low level of almost zero, according to one of the Bank of England’s key policymakers.
In signs of growing Threadneedle Street concern about the fragility of the economy, Gertjan Vlieghe, a member of the rate-setting monetary policy committee, said he would be prepared to cut borrowing costs aggressively in the event that the UK left the EU without a transition agreement on 31 October this year.
The Bank’s official position is that interest rates could move in either direction in the event of a disruptive no-deal scenario, because it would need to assess which was the greater threat: recession or rising inflation.
But Vlieghe used a speech in London to indicate that he saw the risks of a collapse in demand as greater than the risk of inflation caused by the higher costs of imports triggered by a fall in the value of the pound or by the imposition of tariffs.
“On balance, I think it is more likely that I would move to cut [the] bank rate towards the effective lower bound of close to 0% in the event of a no-deal scenario,” Vlieghe said during a speech at Thompson Reuters.
Interest rates were cut to a record low of 0.25% in the aftermath of the EU referendum but have since been raised twice to stand at 0.75%. Vlieghe’s comments suggest that he would be prepared to support something even more drastic than the emergency rate cut announced in August 2016.
He added: “It is highly uncertain when I would want to reverse these interest rate cuts, which would either be driven by an improvement in the underlying economy as the disruptive impact of no deal fades, or by upside risks to inflation if the exchange rate and tariff driven boost to inflation puts upward pressure on medium-term inflation expectations.”
Vlieghe’s comments go further than other Bank of England policymakers. Some have signalled that interest rates would need to be trimmed in the case of a no-deal Brexit but have stopped short of indicating how far they could drop.
The probability that Britain will leave the bloc without a transition agreement has grown since Theresa May announced that she was stepping down as prime minister. Jeremy Hunt and Boris Johnson, the Tory leadership candidates, have said they are prepared to opt for no deal if necessary.
If the UK leaves the EU without a deal it would by default, become a “third country”, with no overarching post-Brexit plan in place and no transition period. The UK would no longer be paying into the EU budget, nor would it hand over the £39bn divorce payment.
The UK would drop out of countless arrangements, pacts and treaties, covering everything from tariffs to the movement of people, foodstuffs, other goods and data, to numerous specific deals on things such as aviation, and policing and security. Without an overall withdrawal agreement each element would need to be agreed. In the immediate aftermath, without a deal the UK would trade with the EU on the default terms of the World Trade Organization (WTO), including tariffs on agricultural goods. This has also been referred to by government ministers as an "Australia-style deal". Australia does not have a free trade agreement with the EU.
The UK government has already indicated that it will set low or no tariffs on goods coming into the country. This would lower the price of imports – making it harder for British manufacturers to compete with foreign goods. If the UK sets the tariffs to zero on goods coming in from the EU, under WTO “most favoured nation” rules it must also offer the same zero tariffs to other countries.
WTO rules only cover goods – they do not apply to financial services, a significant part of the UK’s economy. Trading under WTO rules will also require border checks, which could cause delays at ports, and a severe challenge to the peace process in Ireland without alternative arrangements in place to avoid a hard border.
Some no-deal supporters have claimed that the UK can use article XXIV of the General Agreement on Tariffs and Trade (Gatt) to force the EU to accept a period of up to 10 years where there are no tariffs while a free trade agreement is negotiated. However, the UK cannot invoke article XXIV unilaterally – the EU would have to agree to it. In previous cases where the article has been used, the two sides had a deal in place, and it has never been used to replicate something of the scale and complexity of the EU and the UK’s trading relationship.
The director general of the WTO, Roberto Azevêdo, has told Prospect magazine that “in simple factual terms in this scenario, you could expect to see the application of tariffs between the UK and EU where currently there are none”.
Until some agreements are in place, a no-deal scenario will place extra overheads on UK businesses – eg the current government advice is that all drivers, including lorries and commercial vehicles, will require extra documentation to be able to drive in Europe if there is no deal. Those arguing for a “managed” no deal envisage that a range of smaller, sector-by-sector, bilateral agreements could be quickly put into place as mutual self-interest between the UK and EU to avoid introducing or to rapidly remove this kind of bureaucracy.
Vlieghe said the outlook had deteriorated since his last speech on the economy in February, with the UK no longer being supported by robust global growth. Job vacancies were no longer rising and the upward pressure on wages had stabilised. The Bank has been assuming that the economy moved sideways in the second quarter of 2019, although there is speculation in the City that the official data next month will show a small contraction in output.
The MPC policymaker said that even with a smooth Brexit, he envisaged that it would be a year before interest rates were raised to 1% and two years before they hit 1.25%. By 2022, depending on the state of the global economy, they might still only be 1.75%, well below their 5% level at the time of the banking crash of 2008.
Earlier this week, Silvana Tenreyro, another member of the nine-strong MPC, also warned that the state of the economy made it unlikely that she would vote for higher interest rates.
“Coupled with signs of a weaker global outlook, recent developments likely lengthen the period until there is a sufficient pickup in inflationary pressures for me to vote to raise Bank Rate. I do not currently anticipate such a pickup in the next few months,” she said.
The comments made by Vlieghe and Tenreyro point to a softening of the official MPC line on interest rates in its next quarterly Inflation Report due early next month. In May, the MPC said it expected a gradual and limited tightening of policy.
