Living with uncertainty
23 May 2017
Uncertainty was one of the watchwords of 2016. The vote to leave the EU opened up a wide range of options for what the institutional relationship between the UK and its largest trading partner might look like. This naturally raises important questions, particularly around trade and migration. Quantifying this uncertainty is tricky. One method is through economic policy uncertainty indices which measure news articles containing the terms ‘uncertain’ and ‘uncertainty’ in the context of economic or policy issues. While this measure is far from perfect, it captures a spike in uncertainty last year (see Chart 4). Indeed, there was a seven standard deviation rise in uncertainty in July. This spike dwarfs the uncertainty seen during the financial crisis or neighbouring Eurozone sovereign debt crisis. While the initial spike fell quickly back, uncertainty according to this measure has still remained at unusually high levels since.
The sharp rise in uncertainty had been expected to have short-term economic consequences. Indeed, most forecasters (including ourselves) expected the economy to slow or stall as businesses put off investment and consumers reined in spending. However, the economy held up well in the second half of 2016. The Bank of England has flagged its policy loosening as an important support, although it can probably only take a small part of the credit. Instead it has been the resilience of UK consumers, who continued to spend freely after the vote despite the rise in uncertainty. We have seen business investment soften, albeit not enough to materially dent headline growth. Looking forward, households might find it difficult to provide the same degree of impetus, as rising inflation squeezes real incomes. The outlook for business investment has improved in 2017 according to survey indicators, helped by better global growth, supportive credit conditions and the resilience of UK growth after the referendum. However, the outlook is still for at best subdued spending, with the more trade-sensitive firms still cautious.
The upcoming UK election will do little to address the uncertainty around the relationship with the EU. The signals provided in the major parties’ manifestos around the type of eventual arrangement that they will seek remain vague. The Conservative manifesto reiterates the desire to leave the single market and seek a “close and special relationship” with the EU, including a comprehensive free-trade agreement. However, free-trade agreements are not all alike and the nuance of this deal, particularly around the complicated financial services sector, will be critical. The Labour manifesto states a desire to build a close new relationship with the EU, retaining the benefits of the single market to put jobs and the economy first. This opens up an even broader range of outcomes, with the lack of an immigration target in the manifesto leaving the door open to continued single- market membership – although this may in practice be politically controversial after the referendum. Polling ahead of the election has narrowed, but the Conservatives maintain a large 13-point lead on average over the 10 most recent polls (see Chart 5). If maintained this would suggest a material increase in the Conservative parliamentary majority. However, firms and households will have to wait a lot longer to know what the nature of the final settlement with the EU will look like.
James McCann, Senior Global Economist