Britain's debate about whether to walk away from post-Brexit commitments with the European Union over Northern Ireland risks unsettling an already sputtering economic recovery.
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With the government in London threatening to invoke Article 16 of the Northern Ireland protocol, which governs trade in the region, economists warned that retaliatory measures from Brussels could affect exports and investments and cause a further blow to the pound.
The dangers give a sense of the jolt that could be coming if the U.K. decides to suspend certain trade rules when it leaves the EU. It is likely that it will affect the Bank of England's calculation about when to raise interest rates and address a surge in inflation.
Clients were not interested in the Brexit until last week, but now they are worried that it is back to square one, according to Fabrice Montagne, chief U.K. economist at Barclays Plc.
Here are the risks to the U.K. economy and how policy makers might react to the standoff, with both sides locked in talks to resolve the standoff.
Read more: Brexit Uncertainty Hurts Investment in U.K. BOE s Haskel Says
Market reaction to the U.K. triggering Article 16 will depend on how the government acts. A broad-based repudiation of Britain tearing up the Northern Ireland Protocol could cause a quick 5% drop in sterling, Derek Halpenny, MUFG's head of European global markets research, told Bloomberg Television.
In the long term, the market could face an outlook that is more uncertain and volatile, with this particular dispute being one of many confrontations between the EU and the U.K, according to analysts at BofA Merrill Lynch.
The investors in sterling have had to deal with a number of problems with the currency in the last few months. The BOE's uncertainty about when interest rates will rise is dampening investor sentiment, as a surge in energy prices is slowing growth and boosting inflation.
A big blow up over Brexit could cause the outlook to be unnerved and depress the pound.
A weaker currency would push prices higher at a time when inflation is already running at more than the BOE's 2% target.
Jagjit Chadha, director of the National Institute of Economic and Social Research, said new trade frictions could amplify the supply shortages we have and pose lasting inflationary pressures.
The temporary factors like energy prices and the end of lockdown that the BOE has pointed out to in explaining why it can delay action may be harder to ignore. The longer and longer inflation is above target, the more pressure there is for the Bank to respond to that, Chadha said.
A trade war would only add to the trade-off currently facing the BOE. Trade friction and a weaker pound would give inflation a lift, as more uncertainty would add to the headwinds to growth. It's likely that there is less urgency to raise rates but it won't cause the BOE to relax like it did in 2016. According to Jonathan Portes, a fellow at the Changing Europe research group, the EU could enforce rules of origin checks more strictly, which would increase administrative burdens for exporters. The data adequacy provision that lubricates trade could be revoked by the EU.
It could revive the uncertainty that followed the vote on the subject of the vote. It is important that big investment decisions are put on hold, such as those in the car industry, which were made on the assumption that the trade agreement remains in force, Portes said.
If the U.K. doesn't comply with the protocol, all the EU would have to do is say it will suspend tariff-free access for car production. Gerard Lyons, former economic adviser to Prime Minister Boris Johnson, said Britain's hopes of a trade deal with the U.S. might be one of the first casualties to be triggered by Article 16. A transatlantic trade deal is held up as a key prize from the EU.
U.S. President Joe Biden is proud and vocal about his Irish heritage and has repeatedly raised concerns about any outcome that would threaten peace in the region.
Some pro-Brexit economists are less worried. Julian Jessop, an economics fellow at the Institute of Economic Affairs, said global pressures on energy and food prices would have a bigger impact on inflation and had little influence on the BOE than any Article 16 action.
It will come out in the wash, Jessop said. You'd get slightly higher inflation but you'd have a weaker growth. The Bank hasn't raised rates so far because of uncertainty about the real economy. If it gets another real-economy shock in the form of a trade war, that won't cause it to raise rates sooner. None Boeing Built an Unsafe Plane and Blamed the Pilots When It Crashed None Google Wants to Save the Planet With Satellite Images
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