MNI INSIGHT: BOE Brexit Assumptions Unaffected By Talks Drama

--Ahead December MPC Meet, Policymakers Not Swayed By Brexit Talks

By David Robinson

     LONDON (MNI) - The Bank of England Monetary Policy Committee's economic

projections, based on an orderly Brexit, are insulated from the latest

negotiation tribulations, people familiar with the committee's thinking and

forecasting processes say.

     The MPC's working assumption of a smooth Brexit, culminating in a somewhat

less open UK economy, is pretty robust. It will stay in place unless and until

there is clear evidence that consumers and businesses are acting on a more

pessimistic or optimistic scenario.

     Whatever the denouement of the latest drama in the Brexit negotiations, it

will be noises off for the MPC at this month's meeting. There will simply be too

little time to gauge responses to the Brexit news in the real economy.

     For market participants, the key message from the Bank has been that Brexit

interest rate risks are not one directional. Even if the breakdown and

resumptions of negotiations are viewed by some market participants as, say,

increasing the chances of a hard Brexit, the MPC sees no straightforward read

across to the likely path for inflation and thus Bank Rate.

     The Bank's November Inflation Report projections were again conditioned on

the assumption that "households and companies base their decisions on the

expectation of smooth adjustment to the United Kingdom's new trading

relationship with the European Union."

     To overturn that assumption would require plenty of data showing that

consumer spending was slowing even more than the Bank had assumed or that

relatively weak business investment growth was set to decelerate markedly.

     Nor is the Bank going to revisit any time soon its approach of 'averaging

out' final Brexit outturns. Where the UK ends up at the culmination of the

Brexit process is unknowable, not least because the government has yet to decide

where it wants to go, a point noted by Bank officials in recent weeks. 

     Chancellor of the Exchequer Philip Hammond confirmed to the Treasury Select

Committee on Wednesday that the cabinet has not only yet to agree a mandate, it

has yet to even hold a formal meeting on what end state it wants.

     The BOE average of end states excludes the extremes of disorderly Brexit,

interpreted as a sudden shift from EU membership to operating on World Trade

Organisation rules with no exit deal, and Brexit never happening.

--PRICING MARKET EXPECTATIONS

     Markets, unlike the Bank, have been placing some weight on extreme

outcomes. The headline market rate assumption is based on the sterling overnight

index average (SONIA), a mean measure of rate expectations with its forward

interest rates represent the probability weighted average of possible outcomes. 

     SONIA implied rate expectations moved sharply higher on November 29 to

place around a 60% chance on a May 2018 hike over optimism about the UK and EU

agreeing to a Brexit finacial settlement and fleetingly moved up again earlier

this week when an agreement over the Irish border question appeared,

momentarily, to be on the cards. 

     Alternative measures of interest rate expectations, such as options

pricing, suggest that the message that interest rate risks around Brexit news

should be more evenly spread may have been taken on board. 

     BOE Deputy Governor Ben Broadbent used a November 15 speech at the London

School of Economics to hammer home the message that the MPC would not

mechanistically move Bank Rate up or down depending on Brexit developments. What

matters for the MPC is the interplay between supply and demand, reflected

through consumer and business activity, and currency movements.

     An increased likelihood of a smooth, soft Brexit could bolster the UK

supply side through increased business investment and curb inflation pressure

through stronger sterling, and if consumer spending only held steady that would

weaken the case for further Bank Rate hikes. An increasing likelihood of a hard

Brexit could do the reverse if sterling falls, supply is hit but consumer

spending holds up.

--POLICY ON HOLD

     From a policymaker's perspective, with inflation projected to hold above

the 2% target, markets lowering rate expectations in response to news of

disruptions to the Brexit process could be counter productive.

     When the BOE MPC hiked Bank Rate by 25 basis points in November, it dropped

the line it had used in the Inflation Report that markets may be under-pricing

the likelihood of tightening. In its November forecast, conditioned on Bank Rate

rising from 0.25% before that meeting to 1%, inflation drifted down to 2.1% by

the end of the three-year forecast horizon.

     The MPC's summary and the subsequent commentary by BOE Governor Mark Carney

and colleagues suggested that the committee was not trying to disturb market

expectations.

     Having yield curves shift down now because of adverse Brexit news flow,

when it is unclear what the various Brexit outturns will do to the inflation

outlook, would not reflect Broadbent's message.

     The response of consumers and business to Brexit developments will be

watched closely by the BOE, but consumer data is highly erratic month by month

and particularly so around the Christmas period. It could be a good while yet

before the MPC will have much confidence about how, it at all, consumer activity

it is being impacted by the Brexit debate. 

     The MPC is expected to leave policy on hold at its December meeting and the

meeting is expected to be pretty low key. The February MPC meeting and forecast

round will see another comprehensive supply side stock take at the Bank but

assumptions of a smooth Brexit are likely to remain in place for a good while

yet.

--MNI London Bureau; tel: +44 203-586-2223; email: david.robinson@marketnews.com

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

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