25 April 2017
Last week, Prime Minister Theresa May surprised voters and markets with the announcement of a snap election only two years after the last general election. Recent polling has seen Conservatives extend their lead even further since their 2015 win, leading Labour by 20ppts on the latest polling average (see Chart 3). Given the strength of the economy and the lengthy negotiations ahead, the timing of the snap election likely reflects a strategic calculation by the Conservatives to strengthen their governmental majority and allow consistency of approach through the EU exit negotiation period. Indeed, current polling would suggest that the Conservative party is set to make material gains in the June vote. Of course, any snap election is a risk and there is also a question whether the Liberal Democrats, campaigning against Brexit, can capitalise in Conservative constituencies that voted to remain. However, even accounting for this, the Conservatives look likely to increase their majority from the slim levels at present.
Markets have taken the snap election announcement positively, as expectations are for Conservatives to succeed in securing more seats, potentially reducing disruptions to the Brexit negotiation process and reducing the likelihood of a veto to any final deal. Just as sterling bore the brunt of the uncertainty brought about by the EU referendum result in June last year, so too has it reflected the slightly more upbeat market mood on this latest political move. Sterling rose 1.8% in trade-weighted terms in the week following the election announcement (see Chart 4) – though it bears reminding that it remains 10% below its pre-referendum level. Since the referendum result, we have had to factor in the impact of the dramatic depreciation of sterling into our own inflation forecasts. Bank of England models suggest that the elasticity of the consumer price index (CPI) with respect to the trade-weighted exchange rate is between 0.18 and 0.27, which is similar to estimates from our own models. That implied that the post-Brexit depreciation of 13% trade-weighted could raise the level of the CPI by 2.3-3.5% over a 3-4 year period.
However, the more recent sterling appreciation prompts an interesting thought experiment: what would a recovery in sterling to, say, pre-referendum levels, mean for the BoE? This is not an easy question. For a start, exchange rate pass-through varies with the broader macro environment and thus a full rebound would not necessarily have the same impact on inflation as the initial depreciation. The Bank’s deliberations would also depend on precisely why sterling had appreciated. Overall, a sterling recovery would certainly cause us to lower our inflation forecasts, with the Bank likely looking at CPI next year close to 2% rather than the 2.5% we currently forecast. In this scenario there would be a trade-off: while the likely smaller and more temporary inflation overshoot would put the Bank under less pressure to tighten policy to comply with its inflation mandate, lower inflation would also reduce the squeeze on households’ real incomes, strengthening all-important consumer demand and overall economic growth. On balance though, we think that in these circumstances, the BoE would likely feel sufficiently confident in the overall outlook to signal that a rate hiking cycle was likely to start considerably earlier than the market is currently anticipating.
: Stephanie Kelly, Political Economist