Bank of England may be assuming a rosy Brexit too soon

The markets may have had bigger things to worry about last week than the Bank of England’s statement that interest rates will rise earlier than previously expected – but they were still stunned by the announcement.

Such a hawkish turn would make perfect sense under normal circumstances; inflation is above the bank’s target and there is no sign that the global recovery is abating. But Brexiting Britain’s situation is far from normal.

The BOE raised interest rates in November to 0.5 per cent from 0.25, removing the additional monetary stimulus injected after the Brexit referendum. The BOE governor Mark Carney thinks the time to increase borrowing costs again is soon. The global economy is running at good clip, he reasoned, helping the British economy to absorb the blow from the Brexit referendum by boosting exports. Wages have begun to rise faster, too: official statistics have shown that the annualised rate of pay growth has increased to 3 per cent at the end of 2017.

He also argues that the bank needs to be mindful of the inflation rate, which has risen to 3 per cent, above the bank’s 2 per cent target. The increase in the inflation rate has come primarily due to the sharp depreciation of sterling in the aftermath of the referendum, which has pushed up import prices. The bank believes these effects will fade away, but will soon be replaced by domestic inflationary pressures, such as wages, strengthening the case for earlier and faster hikes.

The problem with this analysis is its underlying assumption that the Brexit process will go smoothly. That may seem like a safe assumption to make right now. Britain and the European Union have moved to the second phase of the negotiations, after striking a deal on a range of issues including the rights of citizens living abroad and the Irish border. There is now talk of a transition period lasting nearly two years after Britain’s departure in March 2019. If this were to happen, the context in which the British economy operates would not change dramatically over the medium-term. This would provide some justification for a hike.

The trouble is that these predictions are riskier than they look.

The so-called “phase one” deal is a lot shakier than both parties admit. The deal had ruled out having some form of hard border between the Republic of Ireland and Northern Ireland. However, since then the UK has said it will not stay in a customs union with the rest of the EU.

The transition deal is also hardly set in stone. As Michel Barnier, the EU’s chief negotiator, warned on Friday, there are a number of substantial disagreements which could make it impossible for Britain to maintain access to the single market temporarily.

There is little doubt that Britain would suffer enormously in the event of a so-called “cliff-edge” Brexit in which there is no transition period. There would be huge disruptions to trade. Many companies would choose to relocate not to lose access to the single market and to avoid regulatory chaos. Even if a transition were agreed, this would not remove the risk that the UK could leave without a satisfactory trade deal, which would have a significant impact on the economy.

The cost of a disorderly Brexit is so high that it seems odd that the BOE would choose to focus mainly on the rosier scenario. Mr Carney believes the monetary policy committee could quickly adjust if things were to turn out for the worse, but it could be too late.

The bank would be wiser to stay put and accept inflation slightly above target until the fog of Brexit has lifted. This will also give a boost to businesses, which, as the latest BOE Inflation Report shows, are investing less than they otherwise would because of uncertainty related to the referendum. There will be time for the BOE to make its move. For now, inaction is probably the best course of action.

A hawkish turn would make perfect sense under normal circumstances. But Brexiting Britain’s situation is far from normal