The OU’s Level 1 module, You and Your Money, is very special. Launched in 2006, it was the first university course in the UK that set out specifically to help you manage your own personal finances as well as gain credit towards your degree. And, going beyond the guidance you find on consumer websites, You and Your Money digs deep, inviting you to understand how personal financial planning is influenced by, and impacts on, the external environment of social, economic and political factors. Few events are more political or more economic than Brexit and the impact on your finances is likely to be profound.
Much of personal finance is about shifting consumption through time. Borrowers increase their ability to consume today (whether on houses, cars, household appliances, food, and so on), accepting that they will have to consume less in future as they repay their debts. Savers reduce their consumption today, hoping that their savings will enable them to consume more later on, for example, when they retire. Shifting consumption in these ways is not costless: borrowers need to worry about the interest rate they pay; savers need to worry about the interest rate and returns they earn and the risks and uncertainties involved (in other words, the likelihood of expected returns materialising). These factors are all heavily influenced by the state of the economy and how policymakers respond, so like it or not everyone has a personal stake in Brexit.
Shifting consumption through time does not usually literally mean transferring consumption itself ‒ in contrast to squirrels (with whom savers are often likened) which do bury the actual food they will eat. We humans use money as an intermediate step. Money borrowed is exchanged for goods and services today; money saved is exchanged later for goods and services. The rate at which money can be exchanged for goods and services depends on their prices. If prices rise over time (inflation), savers will end up being able to consume less than they had planned unless their savings grow by at least as much as inflation. Conversely, inflation is good for borrowers, who see their outstanding debt fall in terms of the goods and services they have to give up in order to pay off the debt.
In a recent speech, Mark Carney, governor of the Bank of England, identified two opposing but interconnected effects of Brexit:
- Lower growth of the economy. Assuming UK trade with the European Union (EU) falls to some extent and the aim is to establish new trading partners, there will be a transitional period while businesses adjust. During this time, uncertainty about where to focus new trade and investment and lower demand from Europe for UK exports may cause the economy to grow more slowly than it would have done with jobs being lost and wages continuing to be depressed.
- Higher prices. Expectations of lower growth will cause financial markets to downgrade the pound, pushing up the price of imported goods and services for UK consumers and businesses. Carney reckoned that each 10 per cent fall in the sterling exchange rate ultimately causes consumer prices to rise by around 1.6 per cent, although it can take up to four years for the full impact to feed through. Some of this effect is already being felt, with a 20 per cent fall in the exchange rate since the Brexit referendum. Households, feeling the inflation pinch, are beginning to cut back the amount they spend, which further dampens economic growth.
Carney suggested that the net impact is likely to increase UK price inflation (already above the 2 per cent a year target that the government sets) and that the Bank of England’s policy response is likely to be modest and gradual rises in interest rates.
In common with many other countries, UK interest rates have been at historically low levels in the aftermath of the Global Financial Crisis that started in 2007. This has been achieved by cuts to the Bank of England’s official rate and ‘quantitative easing’ (QE) which has involved the Bank of England itself buying government debt and high-quality corporate bonds. The effect of QE is to push down the rate of return on the assets it buys (which ripples through the economy), forcing savers to shift to higher risk investments to seek a return, and making borrowing cheaper.
QE is in part responsible for the glut of household borrowing and for some savers shifting their money into buy-to-let and so pushing house prices beyond the reach of many first-time buyers. It may also explain the government’s ‘freedom and choice’ pensions policy which has encouraged many savers to shun annuities (a product which enables pension savings to be converted to a secure retirement income for life) in favour of drawdown (where pension savings remain invested during retirement) which means pensioners continuing to be exposed to investment risk and the uncertainty of how long their savings must last (longevity risk). If Brexit does lift inflation and help interest rates to climb back off the floor, potentially some of these effects could ease. However, there may be casualties along the way.
Some borrowers may be unable to cope with their loan repayments if interest rates rise. Homebuyers on a fixed-rate mortgage may be protected for a while, but when they come to replace their current deal they need to be prepared for a steep rise in their monthly repayments. If this causes a further squeeze on current consumption, that puts further downward pressure on economic growth, jobs and wages. This is one reason why the Bank of England is likely to raise interest rates only at a snail’s pace.
Savers may celebrate higher interest rates on their savings even if their returns actually lag behind inflation (a perception called ‘money illusion’). Others may opt to stay in higher-risk investments, such as equities (shares). However, those risks are likely to increase. The post-Brexit transition will be a period of great uncertainty for UK businesses, especially those that export or rely on imported inputs. This means UK company share prices may be depressed and more volatile in the short to medium term. The answer is to diversify, building investment portfolios that include exposure to overseas economies, though the costs and risks of doing that increase if the exchange rate is low and volatile. Moreover, Brexit is taking place against a backdrop of other major longer term changes, such as the worldwide ageing of populations, technological change and, outside the UK, continuing globalisation. These factors are tending to depress interest rates globally, so it is unlikely that savers and investors will see a return to the easy pickings of past decades.
Whether you are a borrower, a saver or both, Brexit means that you need to steel yourself and your money for a bumpy ride over the next few years. As for the longer term…? Only with hindsight will we know if Brexit does deliver all that the 'Leave' campaign promised.