Bank of England governor Mark Carney has told members of the Treasury select committee that interest rates would “more likely than not” be cut in the events of a no-deal Brexit.
Mr Carney said the job of the central bank in the event of the UK leaving the EU without a deal and without a transition period would be to support economic growth while also maintaining inflation close to the 2 per cent target.
Those objectives can be mutually exclusive. For example, if a no-deal Brexit leads to a sharp decline in the value of sterling relative to other currencies, that would lead to higher inflation.
To put inflation back down towards the target level the central bank could put rates up.
But higher interest rates are generally negative for economic growth as they incentivise saving rather than spending and push borrowing costs up, denting the amount of cash available to consumers and businesses.
Lower interest rates would be supportive of economic growth, but would also act to make the currency fall further in value, as the market treats the decision to cut rates as a sign the economy is in trouble. This further fall in the value of the currency would lead to yet higher inflation.
Mr Carney said: “The challenge with actually doing that [supporting the economy] is that a no-deal, no-transition Brexit will be inflationary.”
He said the central bank would provide “what support it can” for the economy, but that economic growth would be very much lower than it has forecast to date if the UK exits without a deal.
If the interest rate cut simply leads to more inflation and not more growth, that would itself lead to weaker growth.
He added that the central bank would try to stimulate economic growth in another way, by making cheap money available to banks in exchange for collateral from those banks.
This method was used in the immediate aftermath of the global financial crisis and the initial Brexit vote.
The idea is that if banks can access cash cheaply and easily, they are more likely to lend to the wider economy, stimulating economic growth.
Edward Park, deputy chief investment officer at Brooks Macdonald, said the direction of sterling had a material impact on the FTSE 100, and that whenever sterling rises, the FTSE 100 tends to fall.
This was because the majority of the earnings of companies in the FTSE 100 are generated in other currencies, and the value of those earnings rise as sterling falls.
Source: FT Adviser