UK economy has downshifted markedly following the referendum – Wells Fargo

Jay H. Bryson, Global Economist at Wells Fargo, notes that the recently released data showed that real GDP in the United Kingdom grew 0.6 percent (not annualized) on a sequential basis in the second quarter.

Key Quotes

“So why did the Monetary Policy Committee (MPC) of the Bank of England this week decide to provide further policy accommodation? Although the economy may have grown at a stronger-than-expected pace in Q2, the outlook has deteriorated notably since voters decided to leave the European Union in the referendum that was held on June 23.

There is little “hard” economic data from the third quarter yet, but the “soft” data that have been released so far suggest the economy has downshifted markedly in the weeks following the referendum. For example, the respective purchasing managers’ index for both the manufacturing and service sector fell below the demarcation line separating expansion from contraction in July. Retail sales plunged 0.9 percent in June, the month in which the referendum was held, and survey data suggest that retail spending weakened noticeably further in July.

We believe the British economy is slipping into a modest recession. We look for real GDP in the United Kingdom to fall a bit more than 1 percent on a peak-to-trough basis over the next three quarters. In our view, the uncertainty that Brexit creates regarding the eventual economic relationship that the country will maintain with the European Union will lead to a sharp pullback in U.K. investment spending. The MPC has not gone so far as to forecast outright recession, but it marked down its growth forecast for next year significantly. It also acknowledged that the depreciation of sterling in the aftermath of the referendum would lift the overall CPI inflation rate, at least in the near term, due to higher prices of imported goods.

In response to the deterioration in the economic outlook, the MPC decided last week to take a number of steps to ease its policy stance. First, it cut its benchmark policy rate, which has been maintained at 0.50 percent since March 2009, to 0.25 percent. Second, it expanded the size of its government bond buying program (i.e., its quantitative easing program) to £435 billion from £375 billion. Until this point, the Bank’s asset purchases had targeted government bonds exclusively. The MPC decided yesterday to expand its QE program to include up to £10 billion of corporate bonds. The MPC also announced the creation of a Term Funding Scheme that is intended to provide liquidity support to banks on a long-term basis. The MPC envisions that the scheme will encourage banks to increase their lending to the real economy.

We believe the MPC likely will ease policy further as the economy weakens. The British pound has depreciated more than 10 percent vis-à-vis the U.S. dollar since the Brexit referendum. In our view, sterling will slide further against the dollar in the coming quarters as the MPC’s policy turns more accommodative.”