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COLUMN-The asymmetric risks of betting on a 'smooth' Brexit: James Saft
May 11, 2017 / 8:53 PM / 4 months ago

COLUMN-The asymmetric risks of betting on a 'smooth' Brexit: James Saft

(The opinions expressed here are those of the author, a columnist for Reuters)

By James Saft

May 11 (Reuters) - The Bank of England basing its forecasts and policy on a ‘smooth’ Brexit ignores its, and Britain’s, asymmetric risks to the downside.

That’s the good news; the bad news is that the BOE probably hasn’t got the tools to handle even a mildly bumpy divorce from the European Union, much less a botched one.

Leaving interest rates on hold at 25 basis points on Thursday, the BOE once again forecast an eventual return to robust wage growth, in combination with a Brexit process which includes a comprehensive trade agreement and continued access to the single market for British firms throughout the forecast period.

Considering British Prime Minister Theresa May’s aggressive and unrealistic stance thus far, and the united front presented by European negotiating partners, that is a rather large assumption.

“The risks to the Monetary Policy Committee’s growth projections, therefore, lie overwhelmingly to the downside, given the real possibility that Brexit negotiations turn acrimonious,” Samuel Tombs of Pantheon Macroeconomics wrote in a client note.

Asked in the press conference if the BOE had modeled a messier Brexit, Governor Mark Carney said it had not:

“We would have had to do an alternative forecast with some variant of a disorderly negotiating process, and we have not done that,” he said.

That would have been tiring, I see that.

Just as everything looks like a nail to a man with a hammer, nothing, apparently, looks like it may require interest rate reductions or extraordinary measures to a central bank, like the BOE, with little room to maneuver.

In other words, don’t ask questions if you won’t have an adequate answer to the results. With only 25 basis points between it and the zero lower bound, even a garden variety downturn, which the UK may well suffer soon, may show BOE tools to be inadequate.

Beyond assuming the negotiations are smooth, the BOE is also reckoning everyone else will go out on this particular limb.

Baked into their forecasts are expectations that weak sterling will attract investment into new production, driving wages at last higher, and that households will then spend optimistically again.

Since both consumers and prospective foreign investors can read, they will have read the accounts of May’s recent dinner with EU Commission President Jean-Claude Juncker which he described, to German Chancellor Angela Merkel, as demonstrating the prime minister as “deluding herself” and unprepared for the length and difficulty of negotiations. Inbound investment to take advantage of a weak pound will be much less than would normally be true until Brexit is more settled.

BREAKDOWN AS A STRATEGY?

The BOE, like Britain, is in a tight spot; weak sterling has led to above-target inflation - about 3 percent this year - at the same time wage growth continues to lag and living standards decrease.

“This is going to be a more challenging time for British households,” Carney said. “Real income growth ... will be negative (and) wages won’t keep up with prices.”

A wage hike anytime soon is thus out of the question.

And while it is true, and the BOE explicitly said, that it cannot insure Britain against the costs of leaving the EU, there seems no question that the central bank should be preparing for the possibility of a rocky exit. Or at the very least, for a Brexit-induced slowdown even in the event matters proceed slowly and damagingly.

There is such a disconnect between Britain’s relatively weak position in seeking exit terms and its blithe bluster that some have begun to speculate that the end in mind is anything but a ‘smooth’ exit.

“It is a lopsided affair, in which the British hold few cards,” Peter Ludlow, a man with long experience of EU affairs, writes in a client note for Llewellyn Consulting.

“Not surprisingly, therefore, there are those in London, but also in Brussels, who regard Mrs May’s stance as calculated - that she is planning for a breakdown, because any agreement on European Council terms would be indefensible in British politics. Breakdown might, for her, be the easy way out.”

Perhaps a resounding victory in upcoming June elections will give May the freedom to show, and negotiate from, weakness, but this is a risky game for her and for Britain. On the evidence of the BOE’s performance Thursday, this is a risk they feel they must run.

If a downturn comes, so will the time to discuss extraordinary monetary policy, or rather more extraordinary monetary policy. If Brexit really turns ugly the discussion will turn to capital and foreign exchange controls. For the central bank to discuss this now avails not, and probably can only harm.

The rest of us had better do it for ourselves. (Editing by James Dalgleish) )

Our Standards:The Thomson Reuters Trust Principles.
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