Holger Breinlich, Elsa Leromain, Dennis Novy and Thomas Sampson / Nov 2017
On 23 June 2016 the UK voted to leave the EU. Most economists agree that Brexit will be bad for the UK economy in the long-run. But how has the referendum affected households in the first year since the vote? Our new research sheds light on this question by looking at how the Brexit vote has affected inflation and the cost of living.
The main finding is that the Brexit vote has reduced living standards by driving up inflation and reducing real wage growth. The costs are evenly shared across the income distribution, but not all regions suffer equally. London is the least affected, while Scotland, Wales and Northern Ireland lose the most.
The Brexit vote was an unexpected shock to the UK economy that took most people (including financial markets) by surprise. As soon as the outcome became clear the pound depreciated sharply. This decline persisted in subsequent months, with sterling still around 10 percent below its pre-referendum value by November 2017 as shown in Figure 1.
Figure 1: Value of sterling, 2015-17
Source: CEP calculations.
Notes: Import weighted effective exchange rate calculated using 2013 UK import shares and monthly average exchange rates. Normalised to 100 in January 2015.
Economic theory predicts that a strong and sustained depreciation of a country's exchange rate should lead to an increase in inflation. In fact, CPI inflation in the United Kingdom rose from 0.4 percent in June 2016 to 2.6 percent in June 2017 and 3.0 percent in October 2017. But it would be a mistake to automatically attribute this entire increase to Brexit. Inflation has also increased in the US and the euro area over the same period.
To disentangle the referendum effect from other sources of inflation such as oil price movements and global inflationary pressures, we study how price increases depend upon the share of imports in consumer expenditure. Tradeable goods such as fruit, wine and clothing have high import shares, while services like restaurants and hotels depend less on imports. If the decline in the pound is responsible for higher inflation, we’d expect products with larger import shares to experience bigger price rises.
Figure 2 shows inflation before and after the referendum for two groups of products: the top half of products in terms of import shares, and the bottom half. Following the referendum there is a rapid increase in inflation for the high import exposure group, while the rise in inflation is slower and much more muted for the low exposure group. This demonstrates the impact of the referendum on import costs and inflation.
Figure 2: Import shares and inflation, 2015-17
Source: CEP calculations.
Notes: High import exposure is products with import shares above the sample median. Low import exposure is products with import shares below the sample median. The figure plots the unweighted average inflation rate for each group expressed as the difference from the group average in January 2015.
After taking account of other factors that affect inflation, we estimate the Brexit vote increased inflation by 1.7 percentage points in the year following the referendum. It would be wise to view the precise magnitude of this effect with some caution, but it is clear that the effect is substantial. A 1.7 percentage point increase in inflation implies that, by June 2017, the Brexit vote was costing the average household £7.74 per week through higher prices. This is equivalent to £404 per year. By increasing prices without affecting nominal wage growth, the referendum has also reduced real wages, costing the average worker almost one week’s wages.
The data shows that, even before Brexit occurs, the average British household is already paying a price for voting to leave the EU. But not all households are equally affected. Households that buy a lot of imported goods have faced bigger price rises than households that mostly purchase products produced in the UK. This allows us to study the distributional consequences of the Brexit vote.
The referendum increased inflation by approximately the same amount for poor, middle income and rich households meaning that the costs of voting for Brexit are evenly shared throughout the income distribution.
However, there are stark regional differences, as shown in Figure 3. London is the least affected region with a rise in inflation 0.35 percentage points below the UK average. The increase is smaller for London primarily because Londoners spend relatively more on rent than the average household and rent has a very low import share.
In general the north of England is harder hit than the south. Scotland, Wales, and Northern Ireland are the worst affected areas. Our estimates imply inflation in Northern Ireland increased by 0.47 percentage points more than the UK average because of the Brexit vote. This is because households in Northern Ireland spend relatively more on food and drink, clothing and fuel, which are high import share products, and relatively less on rent and sewerage, which have low import shares.
Figure 3: Inflation differences across regions due to Brexit vote
Source: CEP calculations.
Notes: For each region we show the estimated inflation increase due to the Brexit vote minus the average increase for the UK.
Is it surprising that the Brexit vote has hit living standards while the UK is still part of the EU? Not at all. Economic behaviour depends upon both the current state of the world and expectations about the future. The referendum increased uncertainty and led to a decline in the likely future openness of the UK to trade, investment and immigration with the EU. Consequently, financial markets downgraded their beliefs about the UK’s economic future, leading to the decline in sterling. Through this channel concerns about the long-run effects of Brexit have already begun to hurt UK households. And there will likely be more pain on the way as Brexit becomes a reality.