The shock of British Prime Minister Theresa May's Conservative Party losing its majority last week in the UK general election has left the British pound softer and the markets confused. Ever since Article 50 of the Lisbon Treaty was triggered in March, signaling the beginning of the two-year Brexit process, the UK has lost three months of negotiating time with the EU even as PM May got less than what she gambled for. She now has to deal with a hung parliament to get things moving.
While political uncertainty in the UK has been elevated, the EU has become more united, especially after the recent victories of German Chancellor Angela Merkel and French President Emmanuel Macron in their respective elections. Voters have signaled that PM May's vision of a hard Brexit with strict austerity needs to loosen.
In the midst of the political turmoil in the UK, a material economic impact has already kicked into the UK economy even before any EU negotiations have started: Inflation. It is eating into British consumers' ability to spend as their wages are stalled, resulting in lower disposable income.
The UK inflation rate in March rose to 2.7 percent, its highest level in four years. It easily surpassed the Bank of England's inflation target of 2 percent. At the Bank of England's policy meeting this week, the BOE did not raise interest rates - though it was a close call with the vote 5 to 3.
This rising inflation is not due to a stronger UK economy. It's the result of the collapse of the pound last year after the Brexit referendum passed.
Much of it is "import-price inflation," with the price of imported goods rising due to the weaker purchasing power of the GBP. This effect is being felt now because it typically takes about six months for exchange rate values to be reflected in consumer prices, since there is some lag time before retailers update their pricing to reflect the exchange rate.
BOE Governor Mark Carney said he believes that with the pound's recent stability, inflation will eventually abate, which is one reason the BOE declined to raise interest rates this week.
My View: Even before any deal is struck with the EU, a further fall in the GBP and continued heightened inflation is likely to materially lower British consumers' disposable income. That means the direction of the GBP has a vital impact on their day-to-day lives. A "hard Brexit" is expected to push the GBP lower because it could result in bad trade terms for the UK. If the negotiation process turns into a "soft Brexit," the pressure on the pound may be a bit relieved. The real danger is if the process becomes so sluggish due to political obstacles within the UK Parliament that there is no deal reached with the EU within the two-year time frame. This would be detrimental - and an outcome that the UK needs to avoid at all costs.
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