In recent months, the expected paths of policy interest
rates in advanced economies have shifted sharply lower, most
notably in the US where an expectation of two further rate
hikes over the next three years has flipped to four rate cuts
by the end of next year. In the euro area, markets have begun
to price in further rate reductions and asset purchases.
Long-term government bond yields have fallen sharply in
tandem, with US 10-year yields their lowest in two and a half
years, 10-year gilt yields their lowest since the immediate
aftermath of the referendum, and German 10-year bund yields
their lowest ever. $13 trillion of global investment-grade debt
is now trading at negative yields. Lower discount rates have
provided substantial support to equity prices, which are near
all-time highs in the US despite an economic outlook that is
becoming less robust and more uncertain.
The global outlook
These market developments reflect a sea change driven by
growing concerns over the impact of rising trade tensions and
policy uncertainty. Certainly, the portents are worrying. The
storm that the modern Prospero has conjured is having an
impact. Over the past year, the global economy has shifted from
a robust, broad-based expansion to a widespread slowdown, with
the proportion of the global economy growing above trend
falling from four fifths to one sixth.
In its May Inflation Report, the MPC projected that global
growth would soon stabilise before recovering to around its
potential rate by the middle of next year. This reflected:
- the relative absence of fundamental
imbalances in the global economy that would by themselves be
expected to derail the expansion;
- a considerable degree of expected policy
support to the expansion; and
- some positive momentum in trade
On 5 May, with the ink on the [Bank of England] Monetary
Policy Committee's (MPC) Report barely dry, President Trump
announced further increases in tariffs on imports from China
and China retaliated. Later that month, the US additionally
threatened new tariffs on Mexico despite having only recently
agreed a revised NAFTA accord. The US threat to increase
tariffs on auto imports from Europe remains.
The longer current tensions persist, the greater the
risk that protectionism becomes the norm
The latest actions raise the possibility that trade tensions
could be far more pervasive, persistent and damaging than
previously expected. The rationales for action are broadening.
Initially motivated by concerns over bilateral trade
imbalances, trade measures are now being taken in response to
issues ranging from immigration to intellectual property
protection, to control of the technologies underpinning the
Fourth Industrial Revolution.2 It has even become
fashionable for some to speak of a new Cold War.
That bears a moment's reflection, for a lot has changed. At
the height of the Cold War, US-USSR trade was worth $2 billion
a year; today, US-Chinese trade clocks $2 billion a day. More
broadly, trade in intermediate goods and services has doubled
since the fall of the Berlin Wall, and production has become
increasingly integrated across borders.3 The longer
current tensions persist, the greater the risk that
protectionism becomes the norm.
Once raised, tariffs are usually slow to be lowered.
Consider that half a century ago the US imposed tariffs on
light trucks due to a dispute over chicken exports to Europe.
While the chickens were soon forgotten, the truck tariffs
remain in place.
Reflecting the more febrile atmosphere, a trade war has shot
to the top of the risks most worrying investors and measures of
global economic policy uncertainty have reached record
Such concerns are contributing to sharp reductions in
corporate earnings expectations, though for the time being the
falls in expected policy rates have cushioned the impact on
equity prices. The markets' faith in the power of monetary
policy is notable.
Business confidence has fallen across the G7 to its lowest
level in five years with sentiment among manufacturers
particularly weak. Households have also become gloomier about
the general economic outlook, though they remain relatively
upbeat about their own financial situation, likely reflecting
robust labour markets. This is a similar pattern to that which
emerged in the UK following the referendum.
Reconciling market moves with global developments
All in all, the risks to the global economy have shifted to
the downside. But to what extent? Does the sea change in
financial markets presage a sea change in the global economic
outlook? And what does the UK experience suggest? A lot will
rest on the scale and breadth of the trade effects.
Traditional trade models suggest that the direct effects of
the tariff measures implemented so far4 are likely
to be small. The Bank estimates that these measures will reduce
global GDP by only around 0.1%, and the further US-China
tariffs that took effect in May and June will roughly double
Across the G7, the growth rate of business investment
has almost halved since its peak in late 2017
But that may not be the end of the story. The additional
tariffs threatened by the US on China and on auto imports more
generally would raise average US tariffs to rates not seen in
half a century. If implemented, they could reduce global GDP by
an additional 0.6% through direct trade channels alone.
Moreover, these estimates may underestimate the non-linear
effects of tariffs on tightly integrated global supply
In this regard, the early indications are not promising. The
more hostile and uncertain trading environment is coinciding
with sharp slowdowns in global trade, manufacturing, industrial
production and capital goods orders. As a consequence, the
quality of global growth has deteriorated. Across the G7, the
growth rate of business investment has almost halved since its
peak in late 2017, leaving the global expansion more reliant on
consumer spending and reducing its resilience.6
As the experience of Brexit has shown, the indirect effects
of trade tensions on business confidence and investment can be
much more material than the direct effects alone. UK business
investment has flat-lined since the referendum, underperforming
both previous recoveries and the international experience.
There is also evidence that these uncertainty effects are
holding back foreign direct investment in the
The UK's experience can be used to assess the extent to
which the deteriorating trade outlook can explain the sea
change in financial markets.
There are three ways to measure the scale of the UK
- First, by using evidence from the Bank's
Decision Maker Panel survey of companies.8 Since
the referendum, Brexit has ranked as one of the three most
important sources of uncertainty for over one third of
respondents to this survey – and for one half since
autumn last year.9 Investment growth has been
persistently weaker among these companies, reducing total
business investment by an estimated 6% to 14%.
- Second, by comparing the performance of
business investment in the UK with the rest of the G7. Prior
to Brexit, UK business investment was growing in line with
the average across the rest of the G7. Since then, it has
risen by just 1% in the UK, while it is up by 12% on average
elsewhere, and by 16% in the US.
- And third, by comparing to pre-crisis
trends. The current level of business investment is some 20%
below the MPC's projection from May 2016, conditioned on a
vote to remain.
These three approaches average to a 12% hit to UK business
investment caused by Brexit uncertainty.
To compare that to what markets may be pricing in for global
trade effects, consider that expected policy rates in the US
have fallen by around 150 basis points since the first trade
measures took effect in July last year. That is enough to
offset a reduction in GDP of some 1.5%10 –
three times the Bank's estimate of the hit from the direct
effects of the tariffs implemented so far.
Indeed, the scale of market moves suggests a shock to US and
Chinese business confidence and investment analogous to what
has happened in the UK.
That seems a bit extreme, since the US and China are far
less closely integrated through trade, financial and labour
market linkages than are the UK and the EU. For example, 45% of
the UK's trade is with the EU, while under 20% of the US's
trade is with China and only 7% of China's trade is with the
It is possible that concerns about still-quiescent inflation
in major economies and the related risk of a global liquidity
trap are contributing to the recent large moves in interest
rates. In the US, core personal consumption expenditure (PCE)
inflation fell back below the FOMC's 2% target earlier this
year. In the euro area, core inflation has been hovering around
1% for much of the past five years. For both economies, market
measures of long-term inflation expectations have drifted down
over the past year.
Persistent low inflation could signal that the equilibrium
interest rate – the rate consistent with inflation at
target and the economy operating at full capacity – is
lower than currently assessed, and therefore the stance of
monetary policy is tighter than intended. Here again, trade
tensions and wider economic policy uncertainties are relevant
as both could reduce the equilibrium interest
rate.11 If so, that monetary policy space could be
more limited in some jurisdictions, increasing the desirability
that fiscal policy supplement it if a downturn
Global developments, Brexit and UK monetary policy
Now consider the implications of global developments for the
outlook for UK inflation and growth.
Unlike many other jurisdictions, inflation in the UK is
currently at the MPC's 2% target, the labour market remains
tight with wages and unit labour costs growing at
target-consistent rates, and inflation expectations of UK
households and businesses remain well-anchored.
The UK outlook also continues to be shaped by Brexit.
Until the turn of the year, the UK economy had been growing
around its trend rate. As the MPC had anticipated, this year
increased Brexit uncertainty is causing volatility in the UK
data. Output increased by 0.5% in the first quarter of this
year, boosted by an important contribution from companies
bringing forward production to build stocks ahead of the
potential March 29 cliff edge.
45% of the UK’s trade is with the EU,
while under 20% of the US’s trade is with
China and only 7% of China’s trade is with
Growth in the second quarter will be considerably weaker, in
part due to the absence of that stock building effect and
Brexit-related, temporary shutdowns by several major car
manufacturers.12 Recent data also raise the
possibility that the negative spillovers to the UK from a
weaker world economy are increasing and the drag from Brexit
uncertainties on underlying growth here could be intensifying.
The latest surveys point to no growth in UK output.
Looking across the first half of the year, in my view,
underlying growth in the UK is currently running below its
potential, and is heavily reliant on the resilience of
The intensification of trade tensions has increased the
downside risks to global and UK growth. In this regard, the
news at the weekend [June 29-30] that the US and China agreed
to restart trade talks is welcome – though as we have
learnt, progress today is no guarantee of progress
To recap, the direct effect of the measures announced thus
far would have only a marginal impact on the UK, of -0.1% of
GDP. That would rise to -0.4% if all measures, including auto
tariffs, were implemented. If there were a Brexit-style
business confidence shock in the US and China, the total impact
on the UK would start to be material, rising above -1% of
Since the middle of last year, expectations of UK rates
three years ahead have fallen by around half a percentage point
and 10-year gilt yields are similarly lower. That would roughly
offset the hit to UK GDP in the downside scenario of a
significant, Brexit-like hit to US and Chinese business
But global trade tensions are not the only factors
influencing UK financial conditions. They also remain highly
sensitive to the perceived probabilities of different Brexit
outcomes. That's because asset prices are mean expectations,
reflecting the weights that market participants place on every
Over the past two months, markets have placed a growing
weight on the possibility of No Deal, with the betting odds
doubling to almost one in three.13 Financial market
participants have marked down UK-focused equity prices,
sterling and their expectations for MPC policy
While the MPC would do what it could to support the economy
in the event of No Deal, I would underscore the MPC's caution
that the response of monetary policy to Brexit will not be
As the MPC has repeatedly emphasised, the appropriate
monetary response to Brexit will depend on the balance of its
effects on demand, supply and the exchange rate. A No Deal
outcome would result in an immediate, material reduction in the
supply capacity of the UK economy as well as a negative shock
to demand. There is little monetary policy can do to offset the
former. A major negative supply shock is extremely unusual in
advanced economies – the last one was the 1970s oil
shock, even if the possibility of the next one is brewing in
Given the exceptional circumstance associated with Brexit,
the MPC would use the flexibility in its remit to support our
economy's transition as much as possible. But there are clearly
limits to our ability to do so. The MPC can stretch the horizon
over which it returns inflation to target but it would never do
so to the point of breaking.
The possibility that Brexit would lower the equilibrium
interest rate and therefore the stimulus provided at a given
level of Bank Rate reinforces this point. In the UK as in other
advanced economies, if there is a material trade shock, other
policies, including fiscal policy, would likely need to play
important roles in supporting the economy.
For now, a global trade war and a No Deal Brexit remain
growing possibilities not certainties. Monetary policy must
address the consequences of such uncertainty for the behaviour
of businesses, households and financial markets. In some
jurisdictions, the impact may warrant a near term policy
response as insurance to maintain the expansion. Markets are
currently pricing in much more stimulus than this, suggesting
greater pessimism about trade developments as well as
potentially concerns about the absence of inflationary
In the UK, the combination of the relatively strong initial
conditions – including a tight labour market and
inflation at target – and the prospect of greater
clarity emerging in the near term regarding the UK and EU's
future relationship argues for a focus on the medium term
inflation dynamics. These will be importantly influenced by
global developments and even more so by the form that Brexit
The MPC's projections for the UK economy are based on the
assumption of a smooth Brexit to the average of a range of
outcomes. That assumption is consistent with the MPC's standard
approach to condition its projections on the government policy
and with the fact that agreeing a deal is the preferred
strategy of both candidates to be the next Prime Minister.
If Brexit progresses smoothly, we expect that the current
heightened uncertainties facing companies and households will
fade gradually, business investment will rebound, the housing
market to rally, and consumption to grow broadly in line with
households' real incomes. This would accelerate economic
growth, strengthen domestic inflationary pressures, and require
limited and gradual increases in interest rates in order to
return inflation sustainably to the 2% target.
Markets have placed a growing weight on the possibility
of No Deal, with the betting odds doubling to almost
one in three
It is unsurprising that the path of interest rates
consistent with achieving the inflation target in this scenario
differs from current market pricing of a lower expected path
for Bank Rate given that the market places significant weights
on both the probability of No Deal and on cuts in Bank Rate in
As the perceived probability of a No Deal has picked up, the
levels of Bank Rate, sterling and other UK asset prices in our
projections have therefore become increasingly inconsistent
with the smooth Brexit assumption in the MPC's projection.
That doesn't mean that the market is wrong or that the MPC
is right about the likely outcome of the negotiations. It just
highlights the extent to which the levels of interest rates,
sterling and other asset prices might increase if a deal were
reached. The MPC will explore how to best illustrate these
sensitivities as we update our projections for the August
We will also make a detailed assessment of the potential
implications of the global sea change currently underway. As I
have sought to illustrate, whether current trade tensions
shipwreck the global economy or prove to be a tempest in a
teacup will have an important influence on the outlook for
growth and inflation in the UK.
However trade tensions evolve and the Brexit process
unfolds, UK monetary policy will remain guided by the constancy
of the inflation target. The MPC will respond to any material
change in the outlook, adjusting policy in either direction, as
required to bring inflation sustainably back to the 2% target
while supporting jobs and activity during this most important
transition for the people of the United Kingdom.
Adapted from a speech given by Mark Carney at the Local
Government Association Annual Conference and Exhibition 2019,
Bournemouth July 2 2019. The full speech with accompanying
tables and graphs is available at www.bankofengland.co.uk/news/speeches
1. Shakespeare used the phrase to refer to a literal change
wrought by the sea. It appears in a song sung by Ariel, to
Ferdinand, a prince of Naples, after Ferdinand's father's
apparent death by drowning: 'Full fathom five thy father lies,
/ Of his bones are coral made, / Those are pearls that were his
eyes, / Nothing of him that doth fade, / but doth suffer a
sea-change, / into something rich and strange, / Sea-nymphs
hourly ring his knell, / Ding-dong. / Hark! now I hear them,
2. In mid-May, the US placed Chinese company Huawei on its
'entity list', in effect banning US companies from selling to
it without US government. China retaliated, publishing its own
list of unreliable entities at the end of that month.
3. Trade in intermediate goods and services doubled between
1989 and 2014 and the value added of imports as a share of
exports rose from 10% in 1990 to around 20% in 2015. See Auer,
R, Borio, C and Filardo, A (2017), 'The globalisation of
inflation: the growing importance of global value chains', BIS
Working Paper No. 602.
4. US tariffs on steel and aluminium and the reciprocated
25% tariff on $50 billion of US imports from China.
5. The hit to global GDP may be cushioned somewhat by trade
diversion, which will likely benefit non-China Asian EMEs.
6. BIS analysis finds that increasing shares of private
consumption in GDP can be a leading indicator of future growth
slowdowns. The work suggests a number of possible mechanisms:
consumption that is financed by debt could mean that subsequent
spending is more constrained; households may choose to consume
from equity gains related to house price rises during
expansions but may need to cut spending if those rises reverse;
and a lack of investment opportunities could also play a role,
weak investment and associated weak GDP growth could show up as
consumption-led growth, not least because consumption is
stickier. For more details, see www.bis.org/publ/qtrpdf/r_qt1703e.htm.
7. Data from the Department for International Trade indicate
that the number of new FDI projects in the UK in 2018/19 fell
to its lowest level in five years.
8. Currently a sample of over 7,000 companies. More details
on the Panel are available at https://
9. Similarly, in the Deloitte Survey of CFOs, 54% of
respondents rated the level of uncertainty as high or very high
in 2019 Q1, up from 25% in 2018 Q2.
10. This assumes a multiplier of 1 – that is, a 1
percentage point fall in the federal funds rate boosts US GDP
by 1%. This multiplier lies between the estimates published by
the Fed for the two variants of their FRB/US model: one in
which expectations are formed using a VAR and the other in
which they are model consistent. In the former, a 1 percentage
point shock to the federal funds rate boost GDP by around
¾%; in the latter, the same shock boosts GDP by around
11. See 'Real interest rates and risk', speech by Gertjan
Vlieghe at the Society of Business Economists' Annual
conference, September 15 2017.
12. As the MPC noted in the minutes to its June meeting,
several major car manufacturers had brought forward their
regular annual shutdowns from the summer to April, as part of
their Brexit contingency plans.
13. These moves in betting odds are consistent with
financial market indicators of No Deal risk, such as the skew
in the option-implied distribution for sterling.
14. Since the referendum, UK-focused equity prices have
underperformed the FTSE-100 by around 25 percentage points and
the S&P by some 45 percentage points. Sterling has hovered
some 15-20% below its November 2015 peak.