Uncertainty is the watchword at present for anyone seeking to assess the prospects of the UK economy. A month on from the referendum, it is clear that Britain’s vote to leave the EU has dealt a severe blow to the confidence of businesses, households and investors. However, it is too soon to tell how hard this has hit activity, and the extent of the long-term damage will depend on the form Brexit takes.
This is apparent in the International Monetary Fund’s update of its outlook for the world economy. It has cut its forecast for UK growth next year by a full percentage point but this assumes a swift deal that keeps the UK within the single market. In this benign scenario, the fallout of Brexit would be concentrated on the UK and its main EU trading partners. In a more adverse scenario, Brexit could halve output growth in advanced economies in 2017.
Given this degree of uncertainty - and the absence of acute stress in financial markets - it is reasonable for both the Bank of England and Philip Hammond, the incoming chancellor, to take time to consider their response.
By next month, the BoE will have at least some evidence of how the Brexit vote is affecting economic activity. This will help them judge how far the depreciation in sterling will push up inflation. This was already rising in June, according to the latest data, as a result of the recovery in oil prices. Yet the effects of a weaker exchange rate are likely to be offset by a fall in business investment, a freeze in hiring and a downturn in consumer spending. Most policymakers expect there will be a case for monetary easing, whether in the form of a rate cut, further asset purchases or a combination of measures.
However, with interest rates at historic lows, the BoE’s options are limited. So it will be important for the government to recognise that fiscal policy may need to play a bigger part in any stimulus than it did in 2008, at the start of the last downturn.
This will be especially important if - as seems likely - higher inflation coincides with stagnation in wages. UK households are only just recovering from a long period of falling real incomes. Even if unemployment remains low, a fresh hit to living standards will make the politics of Brexit even more combustible. Theresa May, prime minister, has rightly abandoned her predecessors’ commitment to run a budget surplus by 2020. But this does not necessarily mean any relaxation of austerity. If the chancellor left existing spending plans unchanged, there could be a breach of fiscal targets and an increase in austerity, since freezes on welfare spending would bite harder in an environment of higher inflation.
One of Mr Hammond’s first tasks must be to rethink the UK’s fiscal framework to ensure it remains credible. But he will also need to set aside any dogma when it comes to the public finances, and make a pragmatic assessment of the need for fiscal stimulus. By the time of the autumn statement, he should have enough information on the trajectory of the economy and the likely shape of Brexit negotiations to judge whether stimulus is warranted.
Treasury officials would do well to spend the summer identifying infrastructure investments that could be rapidly set in train. But given the complexity of large public projects, they should also identify ways to deliver a swifter boost to the economy, such as cuts in consumption tax, incentives for investment, or changes in land taxes that would spur development.
Stimulus policies cannot reverse the long-term effects of Brexit on the UK’s economic potential but there is a great deal that can be done to lessen uncertainty and mitigate the shock.
