Yesterday I read this post by the blogger Ms. ZiYou. If you haven’t checked out her site, you should. Her post isn’t about Brexit but it is about inflation. And it made me think that I should write something about how my small family is starting to think about planning for a “No Deal” Brexit scenario. There are two prongs to this plan. The first prong thinks about supply scarcity and the second prong thinks about money as a store of value that can be eroded away by inflation. At the moment, I have two different strategies to deal with both. The first one is buying stuff (i.e. goods) now and storing it so that if prices do dramatically increase as a result of Brexit supply shocks and a weaker pound, we have enough food supply to get us through 3 months. The second one involves sending money abroad, which I recognise that not everyone can do. I can hold money abroad only because I have lived in a host of other countries, and therefore have other bank accounts, not because I am rich. But it’s definitely something that not everyone can do.
This blog post is going to deal with the latter problem: why you might want to protect against inflation as a consequence of Brexit. I will write another blog post about what kinds of purchases in goods we are making because of Brexit. In summary, given that we are now 8 months away, we are going to try to make additional bulk purchases in our weekly grocery shopping to the order of about 20 pounds a week (so ~ 700 pounds until March), so that it doesn’t break our grocery budget. I’m also thinking about taking up canning food, which is an activity I know how to do having grown up in a small rural community.
But to inflation: Inflation is changes in prices. Prices can go up, down, or stay the same. I always tell people that inflation is like driving a car. Accelerating forward is inflation, slowing down (but still going forward) is disinflation, and going in reverse is deflation. The consensus among most central banks in OECD countries is that healthy inflation, that is a healthy speed forward, is about 2-4%. A country’s level of healthy inflation is tied to how fast the country is growing. If a country has a 10% growth rate then it can more easily cope with higher inflation than if a country has a 1% growth rate (current U.K. inflation is 2.3% and growth 1.8% according to the ONS).
Economists have a concept called pass through and it is this concept that is important for understanding the potential inflationary effects of Brexit. Pass through refers to the correlation between changes in exchange rates and changes in prices. If the exchange rate depreciates (becomes more expensive to purchase foreign goods) then this can have an effect on import prices and consumer prices. Similarly, if the exchange rate appreciates (becomes cheaper to purchase foreign goods) then this can also effect inflation. A recent study of the U.K., published by the Bank of England as a working paper, suggests that the source of the price shock matters for the amount of pass through. In particular, they find that “global and monetary policy shocks … tend to generate greater pass through to consumer prices in the medium term” compared to domestic demand driven shocks.
So it is quite possible that inflation will go up as a consequence of Brexit, at least over the short to medium term. Countering this, however, will be whether or not the U.K. enters into a recession as a consequence of Brexit, and how fast that occurs if it does. Prices can disinflate (slow down) or even deflate (driving in reverse) as a consequence of recessions. This was shown dramatically by the U.S. financial crisis and the subsequent financial crisis in Europe. One difference now compared to then is that with interest rates already at historically low levels, the Bank of England has a much smaller arsenal of tools in its conventional toolbox in order to deal with deflation than it does to deal with inflation. For deflation, the Bank of England would want to make real (i.e. inflation adjusted) interest rates as low as possible (perhaps even negative) whereas in the case of inflation, it would want to raise them.
So what you think will happen to inflation depends on a) how much you expect the pound to move against other global currencies (think capital flight out of the City) and how that will effect pass through; b) how you think the Bank of England will respond and c) how much you think it’s likely that we will go into a recession, how deep the recision will be if we do, and how quickly it will happen.
What to do if you have assets and want to protect yourself and you think that currency prices will be volatile? One thing you can do if you have accounts in multiple currencies is to diversify your currency risk. This means putting your money in USD, Euros, etc. If you can’t do this via a bank account you can purchase cash in other currencies, but then you have to figure out how to securely store it and it also will not pay you any return other than changes in the exchange rate and will depreciate with the country’s level of inflation to which the currency belongs. If you think inflation is going to be high over the medium to longer term, you can also purchase inflation-linked bonds and indicies, for example ‘gilts’ issued by the UK government. They have their principal and coupon payments adjusted according to the official government Retail Price Index (RPI). According to some quick search on the web, Vanguard reports that Inflation-linked bonds currently make up about 25% of the total value of the market in UK gilts.
I’m honestly not sure which way it is going to go. I definitely foresee a large reduction in the pound if it turns out that we have a No-Deal Brexit at least over the short to the medium term, which can drive up inflation. But I also think that a No-Deal Brexit is also going to drive up the probability of recession and disinflation. Because in my household we hold no assets and only debt, our strategy is to just make sure that our international debt payments can be made for 3 months before (in case) the pound collapses (we hold student loan debt in other countries). Rather than wait, I am trying to transfer that money now, i.e. over the next 8 months. This is in addition to buying foodstuffs that will last us for 3 months in case of the worse case scenario.
Let me know what you are doing if you live in the U.K. (maybe you aren’t doing anything) or if you have any other suggestions in the comments below. I know that the Brexiters are saying that all this talk is about scare tactics, but what is the point of having a cash emergency fund if all of a sudden it cannot buy anything?