Central banks’ efforts to revive economic growth and inflation suffered another blow with Britain’s vote to leave the European Union. The vote has unleashed anxiety and uncertainty that will dampen investment, hiring, wages and prices.
In the long run, though, Brexit could prove inflationary. That’s because it may mark a turn against globalization, which in the last few decades has helped hold down prices and wages via lower tariffs, more efficient supply chains, outsourcing and immigration.
The initial response of markets was to assume inflation will fall. The pricing of regular and inflation-indexed bonds suggest expected inflation over the next 10 years has fallen 15 basis points in the U.S., 10 in Japan and 13 in Germany since Thursday’s vote for Brexit. (There are 100 basis points in a percentage point.)
This reflects two factors: lower oil prices will directly hold down inflation in the next few years. Over subsequent years, investors are less confident central banks will get inflation higher. “The Fed’s dovish shift on June 15 helped put a floor under inflation expectations but this has been completely erased since Brexit,” notes J.P. Morgan.
In the United Kingdom, though, expected inflation has risen. In part, that reflects the coming effect of the pound’s devaluation on import prices. That won’t bother the Bank of England for now. In 2008, an even bigger drop in sterling helped send inflation over its 2% target in subsequent years. The bank ignored it, correctly betting that weak demand would ensure that the rise was not sustained. The same logic applies today: it will worry more about the hit to demand than the impact of the currency on inflation, and could cut rates or at least raise them more slowly.
But later on, the picture gets more complicated. Inflation occurs when the demand for goods and services grows faster than the supply. Brexit has hit demand, but could also chip away at supply. If import tariffs rise, that will raise domestic costs. If barriers to exports go up, that will reduce the productivity of British firms. Lower immigration could require firms to raise wages, but also reduce local employers’ productivity as they struggle to fill some positions.
In a May report, the BOE touched on these more complicated dynamics: ” Higher import prices would depress investment somewhat, as a significant proportion of UK capital spending uses imported capital goods. Over time, this would reduce potential output. …This combination of influences on demand, supply and the exchange rate could lead to a materially lower path for growth and a notably higher path for inflation” than if Britain stayed in the EU.
Brexit marks a repudiation of globalization — the movement of goods, services, capital and people across borders. Similar backlashes are underway on continental Europe and in the United States, so the entire world, not just Britain, may suffer supply-side damage.
Lower tariffs and international supply chains have enabled firms to produce for larger markets, specialize, raise productivity and slash costs. More controversially, outsourcing also gives them access to cheaper labor. While the link between immigration and wages is more ambiguous, increased unskilled immigration probably does, at the margin, reduce what low-skilled workers earn. As globalization stalls or even retreats, wage inequality might narrow, yet higher costs would leave both the working class and the affluent worse off. These cost pressures would emerge at a time when productivity growth worldwide is already stagnant.
In theory, central banks can set interest rates over the long run to ensure that demand does not grow faster than supply and thus inflation stays on target. But central banks take their cues from the public and their elected representatives. Populist politicians are more likely to want easier monetary policies and appoint central bankers who agree.
Some economists would actually applaud. They say inflation should be higher than 2% to ensure that interest rates, eventually, are also higher and less likely to hit zero again. Some have called for “helicopter money,” i.e. having central banks print money to pay for tax cuts or higher government spending.
A combination of rising costs as globalization retreats and looser fiscal and monetary policy would be ultimately push inflation, and interest rates, higher. Peter Berezin, of the Bank Credit Analyst, an investment advisory, writes: “Ironically, while Brexit has led to a plunge in long-term bond yields, the longer-term outcome could be higher yields.”