Will policy help or hinder?

The response from policy makers is one of the main reasons that the UK economy has so far weathered the Brexit vote well. And there are reasons to think that monetary and fiscal policy can continue to support the economy as Brexit negotiations progress. According to market expectations, the Monetary Policy Committee (MPC) will start tightening monetary policy in early 2019. But of course, the MPC confounded markets in keeping rates on hold over the post-crisis period, despite a significant overshoot of the inflation target. The MPC did this as it (correctly) thought the overshoot would be temporary. This could well happen again, as there are currently few signs of rises in domestically-generated inflation which could cause a longer overshoot. However, we think that there is much less spare capacity in the economy and greater concerns about the distortionary effects of loose monetary policy than during the last inflation overshoot. So if the economy remains as resilient as we expect in the coming quarters, the MPC could be in a position to start normalising policy in late 2018 and potentially at a faster rate than markets currently expect. Nonetheless, we think that strong productivity growth will contain rises in domestic costs and inflationary pressures. Accordingly, the increases in interest rates should still be gradual compared to the past tightening cycles and, therefore, monetary policy is unlikely to derail the recovery.