This is what we have assumed in our latest Inflation Report forecast, where conditional on a smooth Brexit investment growth resumes in 2020 and 2021 (Chart 9). But we are unlikely to achieve full certainty until the final outcome of negotiations is known, and there is a risk that more persistent uncertainty could push out the pick-up in investment and continue to drag on growth. The weakness of investment also casts further doubt on how durable the resilience of the labour market has been. Usually business investment and employment rise and fall together – in aggregate, businesses either increase hiring and investment at the same time, or they cut them both. For businesses to be increasing employment at the same time that they are reducing investment suggests something unusual is going on. One explanation would be if they are substituting labour for capital, perhaps on the grounds that hiring would be easier to reverse in the event of a shock than capital expenditure. Another would be if demand is shifting away from capital-intensive, export-oriented businesses and into labour-intensive, domestically-focused ones. Either way, this shift away from capital and towards labour matters for the economy. Bank staff calculations suggest it has left the economy around 1½% less capital-intensive than we were forecasting ahead of the Brexit referendum. By itself that reduction in capital intensivity accounts for a ½% reduction in labour productivity, even before allowing for the additional impacts of foregone innovation and process improvement.
It has picked up a little in the recent data as US-China trade tensions intensified, but has also fallen back to below historical averages. This apparent disconnect does not necessarily mean that markets are complacent – the policy uncertainty index might be more sensitive to short-term political developments, while market indices could also be factoring in a belief that monetary policy might be able to offset the impact of shocks. But if market participants are underestimating the extent of political risks materialising, that suggests the potential for sharp price corrections if those shocks do come about. The second risk I want to highlight today, and unarguably biggest risk to the UK economy and UK financial stability, remains that of a Brexit outcome of no deal and no transition. That would have large negative economic effects, both in the Bank’s view and in the views of the businesses we talk to up and down the country (Chart 11). This has been a key focus for the FPC in particular since the Brexit referendum, and we have taken many actions to prepare for and respond to it.