The Brexit vote and inflation – updated evidence

Holger Breinlich, Elsa Leromain, Dennis Novy, Thomas Sampson

When the UK voted to leave the EU on 23 June 2016, financial markets were taken by surprise and the sterling exchange rate depreciated sharply. Since then, UK imports have become more expensive. The original version of this column, published in November 2017, found weaker sterling increased UK consumer prices by 1.7% in the year after the referendum. Updating the analysis using more recent data, we estimate that the Brexit depreciation increased UK consumer prices by 2.9%. This represents an £870 per year increase in the cost of living for the average UK household, meaning people have to work 1.4 weeks longer to afford the same goods and services.

Editors’ note: This is an update of a VoxEU column originally published on 20 November 2017 (jump to the original column here)

The Brexit referendum took place over three years ago, and the UK formally left the European Union on 31 January 2020. While debate about the economic consequences of Brexit has centred on forecasting long-run effects, enough time has now passed to examine how the UK economy has been affected by the Brexit vote (Born et al. 2019, Bloom et al. 2019).

The persistent fall in the sterling exchange rate

In recent research (Breinlich et al. 2019), we analyse the effect of weaker sterling on UK consumer prices. As Figure 1 shows, the import-weighed effective sterling exchange rate depreciated by about 10% immediately after the 2016 referendum.

Figure 1 The depreciation of sterling after the 2016 referendum

Notes: Import-weighted effective exchange rate index calculated using daily data and normalized to 100 on the day of the referendum (23 June 2016, indicated by the vertical line). An increase in the index corresponds to a depreciation.

Two aspects of the depreciation are worth stressing. First, the sudden drop in sterling was unusually large for an advanced economy. As Costa et al. (2019) point out, this was the sharpest exchange rate depreciation to occur in any of the world’s four major currencies since the collapse of Bretton Woods. Second, despite some short-lived appreciations (Manasse et al. 2020), the drop in sterling has proved unusually persistent. As of writing, sterling stands at $1.30 against the US dollar and €1.20 against the euro. These levels are similar to those shortly after the referendum.

Higher prices for imports

Textbook economics predicts that imported goods and services will rise in price if the exchange rate depreciates. We examine this mechanism in detail using consumer price data collected by the Office for National Statistics (ONS) to compute the official UK consumer price index (CPI). The key variation we exploit to tease out the effect of the weaker exchange rate is the difference in import exposure across 84 product groups.

Table 1 Import shares by spending categories

Notes: The aggregate import share is a weighted average using 2016 CPI expenditure weights. The standard deviation is unweighted and calculated across 84 COICOP classes.

Table 1 provides an overview. It shows import shares across 12 spending categories in UK consumer expenditure, accounting for both direct import consumption and indirect consumption of imported inputs used by domestic producers. The import shares tend to be relatively big for manufacturing products, being highest for ‘Clothing and footwear’. For every pound spent, UK consumers spend 49 pence on imports in that category. Import shares tend to be much lower for services. For example, ‘Education’ only has an import share of 5%, while ‘Restaurant and hotels’ has an import share of 17%. The import share of aggregate UK consumer expenditure is 29% and is roughly evenly split between direct and indirect import consumption.

Product groups with higher import shares are more exposed to the sterling depreciation. Consumers should therefore see prices for those products rise faster. We test this hypothesis by analysing whether product groups with higher import shares experienced greater increases in inflation following the Brexit depreciation. Of course, price rises can also be driven by other events that are entirely unrelated to the exchange rate shock, for instance higher global oil prices. We control for oil price movements and as a benchmark we also compare the UK inflation experience after June 2016 to that in the euro area.

Figure 2 provides descriptive evidence on the tight relationship between a falling exchange rate and rising import costs. It shows that after June 2016 as sterling went down, intermediate input import prices rose rapidly.

Figure 2 Intermediate input import prices and the value of sterling, 2015-2018

Notes: Monthly data. The indices are normalized to 100 at the time of the referendum (June 2016, indicated by the vertical line). An increase in the exchange rate index corresponds to a depreciation of sterling.

Figure 3 illustrates that at the same time, the aggregate UK consumer price index started rising faster than the euro area CPI. Figure 4 further breaks down the inflation experience into two groups: products with an above-median import share such as ‘Clothing and footwear’, and those with a below-median import share such as ‘Education’. While the two groups behaved similarly in the euro area, they markedly diverged in the UK. The rise in inflation was clearly concentrated among products with high import exposure. Regression analysis using an event study specification confirms this finding.

Figure 3 Consumer prices in the UK and the euro area, 2015-2018

Notes: Monthly data. The indices are normalized to 100 at the time of the referendum (June 2016, indicated by the vertical line).

Figure 4 Inflation rates in the UK and the euro area by import shares, 2015-2018

Notes: COICOP classes with above-median import shares are allocated to the high import share group and those with below-median import shares to the low import share group. For each of the four groups, inflation is expressed as the average log consumer price difference over the previous 12 months relative to the average group inflation rate in June 2016. Monthly data. The vertical line indicates the referendum date (June 2016).

Exchange rate pass-through

We formally estimate the impact, or ‘pass-through’, of the sterling depreciation on UK consumer prices using quarterly data from 2011 to 2018 at the product group level. We find robust evidence of high pass-through. In particular, we cannot reject the hypothesis of complete ‘import cost pass-through’. This means that when sterling depreciates, the price rise for each product group is given by the product’s import share times the magnitude of the depreciation.

Consequences for households’ living standards

Our results imply that exchange rate pass-through to the overall consumer price index from the Brexit depreciation equals the aggregate import share. Since this import share is 29% for the UK (see Table 1) and since sterling depreciated by about 10%, we estimate that the Brexit depreciation increased consumer prices by 2.9% by June 2018. This is equivalent to an increase in the cost of living for the UK average household of £870 per year. We caution that there is some uncertainty around this estimate, but it is clear that the effect is large. As there is no evidence of a countervailing increase in nominal incomes, our finding implies the Brexit depreciation has had a substantial negative effect on real wages and average UK living standards.

Comparing expenditure patterns of households in different deciles of the income distribution shows that the costs of the depreciation are evenly shared across income levels because there is no systematic correlation between income and the share of imports in household expenditure. However, the inflation impact differs considerably across regions (see Figure 5). Households in Northern Ireland and Wales fared worst since they spend a relatively higher fraction of income on high import share products such as food and drink, clothing and fuel. By contrast, households in London were least affected due to their relatively larger expenditure on rent, which has a low import share. Consumer prices rose by 0.7 percentage points more in Northern Ireland than in London.

Figure 5 Inflation effects by region due to the Brexit depreciation

Notes: For each region we show the estimated inflation increase due to the Brexit depreciation relative to the increase for the average UK household (in percentage points). The increase for the average UK household is 2.9 percentage points. The effects are computed using regional household expenditure weights across COICOP classes assuming complete import cost pass-through and a 10 percent depreciation due to the Brexit vote.

Conclusion

The decision to leave the EU is the most important change in UK economic policy for a generation. There is a broad consensus among economists that the long-run welfare effects of Brexit will be negative, but it will be years before these predictions can be rigorously tested. However, as with other financial assets, exchange rate movements are forward-looking and our results document that the Brexit depreciation has already had a sizeable negative effect on UK households.

References

Bloom, N, P Bunn, S Chen, P Mizen, P Smietanka and G Thwaites (2019), “The impact of Brexit on UK firms”, VoxEU.org, 4 September.

Born, B, G Müller, M Schularick and P Sedláček (2019), “£350 million a week: The output cost of the Brexit vote”, VoxEU.org, 29 May.

Breinlich, H, E Leromain, D Novy and T Sampson (2017), “The consequences of the Brexit vote for UK inflation: First evidence”, VoxEU.org, 20 November.

Breinlich, H, E Leromain, D Novy and T Sampson (2019), "Exchange rates and consumer prices: Evidence from Brexit”, CEPR Discussion Paper 14176.

Costa, R, S Dhingra and S Machin (2019), “Trade and worker deskilling”, CEPR Discussion Paper 13768.

Manasse, P, G Moramarco and G Trigilia (2020), “Political risk and exchange rates: The lessons of Brexit”, VoxEU.org, 17 February.

Original column below (published 20 November 2017)

Brexit is forecast to have substantive economic costs for the UK. Most forecasts analyse long-run effects and are based on the assumption that economic barriers with the continent will rise once Brexit occurs (Aichele and Felbermayr 2015, HM Treasury 2016, Dhingra et al. 2017). But it will be many years before the long-run economic consequences of Brexit become clear.

However, this does not mean it is too soon for the Brexit vote to be affecting the UK economy. 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 impacted the UK economy.

Actual costs rather than forecast costs

In recent research (Breinlich et al. 2017a), we do not forecast the potential effects of Brexit. Instead, we analyse the effects that have already materialised. We exploit the notion that the result of the referendum vote in June 2016 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% 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.

From a researcher’s point of view, the referendum and the resulting depreciation of sterling can be regarded as an exogenous macroeconomic shock that was sudden, strong, and persistent. Our research is the first attempt to trace out the economic consequences of the referendum shock using detailed econometric analysis.

From an exchange rate depreciation to inflation

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 UK rose from 0.4% in June 2016 to 2.6% in June 2017 and 3.0% in October 2017.

But it could be that inflation rose over this period for reasons that are entirely unrelated to the referendum shock, for instance a rise in the global price of oil and other commodities. In fact, inflation also increased in the US and the Eurozone after June 2016 as shown in Figure 2. It would therefore be wrong to attribute the entirety of the rise in inflation to the referendum shock.

Figure 2 Consumer price indices for the UK, Eurozone, and US, 2015-17

Source: Eurostat Harmonised Indices of Consumer Prices.

Notes: All indices normalised to 100 in June 2016.

We deal with this challenge in two ways. First, we compare the UK inflation experience to that in the Eurozone. Second, we use the fact that different types of goods depend to different degrees on foreign imports. For example, imports account for a large share of final consumer expenditure on clothing, footwear, and furniture. By contrast, the cost of housing (rents), education, restaurants, and hotels is not much influenced by the price of imports. So, if the depreciation of the pound was responsible for the increase in UK inflation, we should observe larger increases for goods that are more dependent on imports. To measure import dependence, we calculate the share of imports in consumer expenditure for different products, taking account of both final good imports and imported inputs used by UK producers.

Import exposure and inflation

Figure 3 illustrates our main result. The inflation rate for goods that have a high import exposure (the solid line) shot up after the Brexit referendum. In contrast, inflation for low-exposure goods (the dashed line) remained muted.

Figure 3 import exposure and inflation, 2015-17

Source: CEP calculations.

Notes: High import exposure set includes product groups with import shares above the sample median. Low import exposure set includes product groups with import shares below the sample median. Figure shows the unweighted average inflation rate for each set expressed as the difference from the set average for January 2015.

Econometric analysis confirms the pattern shown in Figure 3. Accounting for differences in product-specific inflation rates that are unrelated to Brexit (such as oil price movements and global inflationary pressures that also led to changes in inflation elsewhere), we find that product groups with higher import shares experienced significantly higher inflation following the referendum. Our estimates imply the Brexit vote increased UK CPI 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.

Consequences for households’ living standards

We next look at the impact of higher prices on household expenditure and living standards. We find that the average household has to spend £7.74 more per week, or £404 more per year, to afford the same purchases. By increasing prices without affecting nominal wage growth, the referendum has also reduced real wages, costing the average worker almost one week’s wages (4.4 working days’ wages, to be precise).

It is clear that 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.

We find that the inflation increase is shared evenly throughout the income distribution but not across regions. As Figure 4 illustrates, 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 4 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. See Breinlich et al. (2017b) for technical details.

Conclusion

The economic effects of Brexit will depend crucially on the outcome of the ongoing negotiations between the UK and the EU. But our results show that even before Brexit has actually taken place, the referendum shock of June 2016 has already had substantial economic costs. By triggering a sharp depreciation of the sterling exchange rate, the Leave vote has pushed up the costs of imported goods and hence inflation. Our results indicate that higher prices are costing the average household £404 per year. We find that these costs are shared evenly throughout the income distribution but not across regions. London is the least affected region, while Scotland, Wales, and Northern Ireland experienced the largest increases in consumer prices.

References

Aichele, R and G Felbermayr (2015), “Costs and Benefits of a United Kingdom Exit from the European Union”, Bertelsmann Stiftung.

Breinlich, H, E Leromain, D Novy and T Sampson (2017a), “The Brexit Vote, Inflation and UK Living Standards”, Centre for Economic Performance Brexit Analysis No. 11, London School of Economics.

Breinlich, H, E Leromain, D Novy and T Sampson (2017b), “The Consequences of the Brexit Vote for UK Inflation and Living Standards: First Evidence”, Technical paper, London School of Economics.

Dhingra, S, H Huang, G Ottaviano, J P Pessoa, T Sampson and J Van Reenen (2017), “The Costs and Benefits of Leaving the EU: Trade Effects”, Economic Policy 32: 651-705.

HM Treasury (2016), The Long-term Economic Impact of EU Membership and the Alternatives, HMSO.