RaboResearch - Economic Research

Brexit update: transition ON!

Economic Report

  • The EU and the UK reached an agreement over a transition period on 19 March 2018
  • Hence, the UK will de facto remain part of the EU until 31 December 2020. However, it will not have a say on new EU laws, but it can start negotiating trade deals with other countries
  • That leaves our base case of a transition period followed by a comprehensive free trade agreement (FTA) unaffected; we also maintain our forecast for economic growth for 2018 at 1.4% y-o-y, driven by weaker private consumption and investments
  • However, a hard Brexit remains a possibility until at least autumn 2018. Moreover, any extension of negotiations on the future trade arrangements into the transition period will have negative implications for the economy.
  • Positive readings on nominal wages and inflation mask weak underlying consumption fundamentals

Co-author: Jessica Saat

Transition period agreed

The UK has one year left as a full member of the European Union. The EU and the UK have agreed on a transition period, starting 30 March 2019 till 31 of December 2020. This is positive for economic continuity as it gives businesses, governments and citizens more time to prepare for the future relationship between the UK and the EU. During the transition period the UK will in effect remain part of the European Single Market and the Customs Union. European legislation will continue to apply to the UK. However, the UK will no longer have a say in the making of new legislation and it will be allowed to start negotiating trade agreements with other countries.

However, the transition period has a couple of drawbacks as well. The first point is that the agreement on the transition period is not legally binding until settlement is reached on the final Brexit withdrawal treaty. This is expected to happen in the autumn. However, for this to happen there are still a few hurdles to overcome. The Irish border will be the biggest challenge. If there is no agreement on this point there will be no transition period. A hard Brexit without a deal is still a risk. In that case trade barriers will come into place immediately.

The second point is that it looks like the transition period is going to be used to further negotiate (details of) the agreement on future relations. While, ideally, the transition period would give businesses a grace period in which they could prepare for the future relationship whose rules and regulations would be set out at the beginning of the transition period. The risk is now that the transition period will come into effect with only political agreement on the main elements of the future trade relation, while many practical aspects that matter to businesses remain to be negotiated. As a result businesses will have to deal with a significant degree of remaining uncertainty till the end of the transition period. As for our base case scenario, we still expect a transition period until 31 December 2020 followed by a Free Trade Agreement somewhere between the EU’s deal with Canada and the agreements with Switzerland. However, the support of Labour for a customs union does increase the odds of a custom union being part of such an agreement.

2018 forecast unchanged

As our base case for Brexit is unaffected by these recent developments, our forecast for economic growth in 2018 is also fairly unchanged. Consequently, we expect economic growth to slow down from 1.7% y-o-y in 2017 (the slowest growth pace since 2012) to 1.4% y-o-y in 2018, driven by decelerating private sector consumption and investments, and despite a slightly looser fiscal stance. The weakness recorded in household spending in 2017 is expected to continue in 2018 (see below). Private sector investments on the other hand will be negatively affected by the uncertainty surrounding the Brexit negotiations outcome. Both will also be affected by expected policy rates interest hikes this year (see below). At this growth pace the UK’s economic performance in 2018 is expected to be one of the weakest in the industrial world.

Moreover, risks to this outlook are tilted to the downside and stem from Brexit negotiations. Since “nothing is agreed until everything is agreed”, a ‘Hard Brexit’ still remains a possibility until at least October 2018 when the EU aims to have the withdrawal agreement signed off. Moreover, politicians could use the transition period to extend negotiations on important aspects of the future relationship between the EU and the UK beyond March 2019. The longer the period of uncertainty gets, the more severe the impact on investments is likely to be. With one year of Brexit negotiations behind us, 14% of EU businesses with UK suppliers have reportedly already relocated part of their activities out of the UK.

Private consumption still weak

2018 brought some good news for UK households, as nominal wages (average weekly earnings) increased by 2.78% y-o-y in January, the highest pace recorded since July 2015, while inflation fell to 2.7% in February, the lowest level in 7 months (Figure 1). Nevertheless, these two positive readings mask weak underlying consumption fundamentals. First, real wage growth is still negative and thus continues to damage purchasing power. As inflationary pressures are likely to persist in 2018, now driven by domestic factors, real wage growth will need some time to enter firmly positive territory, which we do see happening in 2018 on the back of tightness in the labour market. Second, the lag effect of persistently high inflation on consumer behaviour is likely to materialise this year. Third, tighter monetary policy will also act as a drag on consumption through the credit channel. A year of negative wage growth has taken its toll on the budgets of households, whom have continued to resort to consumer credit to contain the impact on their spending pattern. Though weakening in the past half year, consumer credit lending growth has been fairly robust (9.3% y-o-y in January) and credit card lending has even picked up more recently (Figure 2). Despite high consumer credit growth, the retail sector has seen lackluster growth and some companies have been struggling to survive. Rising interest rates will put downward pressure on consumer credit and further hurt the retail sector.

Figure 1: Real wage growth has been negative
Figure 1: Real wage growth has been negativeSource: ONS, Macrobond
Figure 2: Credit card lending picks up
Figure 2: Credit card lending picks upSource: BoE, Macrobond

Bank of England: going for two

The Brexit developments are instrumental for the Bank of England’s policy outlook. More specifically, in its February policy statement the Bank noted that its projections are “conditioned on the average of a range of possible outcomes for the United Kingdom’s eventual trading relationship with the European Union” and assume “a smooth adjustment to that new trading relationship”. The March statement then emphasised that the “developments regarding the United Kingdom’s withdrawal from the European Union […] remain the most significant influence on, and source of uncertainty about, the economic outlook”.

The (still tentative) deal on the transition period should have reduced at least some of that uncertainty and therefore bolster the Bank of England’s Monetary Policy Committee to pursue their plans of two rate hikes in 2018. At the March meeting, they still left the Bank Rate unchanged at 0.50%, but the dissent of two (known) hawks did send a signal that they will strongly urge the MPC to make the well-expected move to 0.75% in May.

Figure 3: Going for two? Money markets in line with MPC outlook
Figure 3: Going for two? Money markets in line with MPC outlookSource: Bloomberg, Rabobank calculations

The policy statement of the March meeting didn’t provide the market with much new information, however. The MPC still expects a build-up in excess demand to feed into higher domestically generated inflation, while also pointing to its reduced tolerance for above-target inflation when economic slack is largely absorbed. Moreover, it refrained from pushing back against market pricing of a May rate hike and we would argue here that its silence gives consent. Current money market pricing looks therefore to be in line with the MPC’s ideas and the Committee has clearly has no interest in upsetting this delicate balance. Our view therefore remains that the Bank of England will hike in May and then again in November.

Alexandra Dumitru
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 60441
Stefan Koopman
Rabobank KEO

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