At the same time, the BoE revised marginally down its inflation projections (Fig. D), while confirming expectations for an increase and a rate above the 2.0% target throughout the forecasting horizon: 2.7% at the end of 2017, 2.6% at the end of 2018, and 2.4% at the end of 2019. After averaging 0.7% in 2016, inflation rose above target already in February, climbing to 2.3%, and is expected to rise further in the course of the year. Mounting inflation risks as a result of Brexit prompted one BoE Board member – Kristin Forbes – to dissent from the decision to leave rates unchanged at the March meeting, and to vote for an immediate hike from 0.25% to 0.50%.

We do not expect Forbes to be joined by other dissenters soon, as for the time being the shared approach is to maintain a certain degree of caution, in light of the downside risks to growth, which may derive from Brexit both in the near term (uncertainty over the outcome of the negotiations) and in the longer run (loss of access to the single market). The importance of Forbes’s dissent as a signal is significantly reduced also when considering that her mandate will end soon, on 30 June.

Furthermore, already within the next few months, an initial immediate effect of the rise in inflation may be the gradual erosion of purchasing power which, combined with still too sluggish wage growth, should result in a deceleration of consumption.

Therefore, we confirm our expectations for a modest weakening of the pound in the near term, both against the dollar (towards GBP/USD 1.22-1.20 on a 1m-3m horizon) and against the euro (towards EUR/GBP 0.87-0.88). In this period, another negative factor could be the uncertainty weighing on the subjects and modalities of the initial phase of the negotiations between the United Kingdom and the EU, which could begin with some delay compared to Theresa May’s desiderata.

This is because an extraordinary EU summit – due to be held on 29 April - is needed to officially approve the draft guidelines for Brexit negotiations already delivered by the President of the European Council Donald Tusk to the 27 member states. As the negotiations between the United Kingdom and the EU may only begin once the Commission will have laid out the directives, there is a risk of the talks not beginning in earnest before the end of May/beginning of June, whereas the May government would want to get to work as soon as possible, as the two-year deadline by which to reach an agreement is calculated from the notification date (29 march).

The main object of the negotiations will be to define a new framework of economic and trade relations between the United Kingdom and the EU. However, other issues, on which tensions are already high and to which the EU seems set on awarding a priority, include: (1) the size of the bill the UK will have to pay to the EU for leaving the bloc in order to cover its past financial commitments under the EU budget (estimated at around 60 billion euros); (2) the question of EU citizens living in the UK. The risk is that negotiations may stall at the very beginning on these issues.

Additional uncertainty is being generated by the request of a new referendum on Scottish independence, to be held between autumn 2018 and spring 2019.

Coming back to the main theme of the negotiations, i.e. the new framework of economic and trade relations with the EU, the negotiations will be far from simple. Loss of access to the single market – inevitable to the extent to which the United Kingdom intends to reacquire full control over immigration (going against the EU principle of free circulation for individuals) – will be a negative development for the UK economy in net terms, the impact of which may be buffered, however, by seeking an agreement which minimises the cost of exiting the single market. The May government aims to reach the best possible agreement, but the EU – at least in the initial phase – cannot show an inclination to make concessions, as this could create a precedent, involuntarily encouraging other the agenda of countries that may intend to exit the EU in the future. It should also be considered that even the best possible agreement with the EU will be worse than current conditions. Should the United Kingdom fail to reach a satisfactory agreement by the end of the two-year negotiation period, the risk of an exit without a prior agreement would take shape, undoubtedly the worst-case scenario for the British economy, as relations with the EU would then be governed by the terms and conditions of the WTO. The May government is working on a contingency plan in case of the risk of an exit without an agreement becoming a realistic prospect.

The complexity, uncertainty and duration of the negotiations suggests that risks to the pound will remain skewed to the downside, both this year and the next.

Beyond the near term – assuming an agreement is ultimately reached that limits the damage of losing access to the single market – we continue to expect a gradual recovery of the pound, towards GBP/USD 1.28-1.32 on a 12m-24m horizon. We opt for a modest recovery trend to take into account the risk of tied to the complexity/length of the negotiations – the deadline for which is the end of March 2019 (which coincides with the two-year horizon). Against the euro, this would imply an EUR/GBP exchange rate of around 0.86-0.87 on a 12m-24m horizon, as the EUR/USD scenario in the same period points to a sharper appreciation of the euro (towards EUR/USD 1.10-1.15 on a 12m-24m horizon). Expectations for a recovery of the pound would in any case be stumped in the event of the United Kingdom ultimately exiting the EU without an agreement: in this case the pound would correct, probably dropping below its post-referendum lows against both the dollar and the euro.

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