The consequences have been immediate. The economic impact of Brexit is most obvious in the depreciation of the sterling. It weakened 12% vis-à-vis the euro and the US dollar in the wake of the referendum result, as investors concluded that leaving the largest internal market in the world would probably be a structural headwind for the UK economy.
However, it’s not all bad news as a weaker pound helps exporters. This explains the strength of the UK economy after the Brexit verdict and the continued (albeit slow) growth in GDP. The benefit to exporters is one reason why the FTSE 100 has not been adversely affected by Brexit. The majority of its constituents, collectively worth £1.7trn, are either major exporters, or conduct the majority of their business outside the UK.
Although a weaker pound is positive for UK exporters, it has also raised the price of imports, particularly food. Subsequently, an important effect of Brexit has been a significant rise in inflation towards levels around 3%, far above the Bank of England’s 2%-target. Real incomes are now declining, as British workers are not compensated for the rise in inflation with pay rises, due to companies remaining cautious amid the increased economic uncertainty.
The kindness of strangers
The weaker pound has also led to an improvement in the balance of payments, as the higher value of exports exceeds the value of imports. Still, the UK is running a trade deficit of around 2% of GDP, and continues to depend on the “kindness of strangers”, according to Bank of England (BoE) Governor Mark Carney.
Rising inflation and a weakening pound pose a dilemma for the BoE’s Monetary Policy Committee, which is becoming more and more divided on the wisdom of keeping interest rates unchanged from the present base rate of 0.25%. Carney said recently that policymakers could lift rates if business investment rises.
Against the background of a weakening economy and lower real household incomes, it is unlikely that the BoE has a lot of leeway to hike rates, but given the rhetoric since the June election, a modest rate hike in the course of this year cannot be ruled out.