By Stephen Fidler Sept. 22, 2016
The sky didn’t fall in on the U.K. economy after the Brexit vote, raising doubts about some of the more gloom-laden forecasts ahead of and immediately after June’s referendum.

The longer until there is any obvious economic setback, the harder it will be to convince skeptics that Brexit was the cause. In British politics, the economy could end up as one of possibly many unresolved Brexit controversies.

That may have important consequences inside the U.K. and for the rest of the European bloc.

John Springford at the Centre for European Reform, a pro-European Union think tank based in London, believes the lack of an immediate recession makes it more likely that pro-Brexit politicians will win their case for a dramatic break from the EU.

A less dramatic rupture would have the U.K. remaining inside the single market—at least temporarily. But there would be a big political downside: The U.K. would still be subject to many EU laws and regulations, including its insistence on free movement of labor.

On the other hand, a so-called hard Brexit would allow the U.K. to deal as it wishes with migrants from inside the EU and stop EU law from trumping British law. Except for having to comply with EU regulations to sell products into the bloc, Britain would be able to forget EU rules and regulations.

That would likely entail more disruption to the British economy than retaining single-market membership, even if it negotiated a trade agreement with the EU that put the U.K. in a privileged position compared with others, such as the U.S., with no such agreement.

But continued U.K. economic resilience would also have a potential impact on the rest of the EU. Many pro-EU politicians on the Continent had assumed that Brexit would deliver such a strong short-term shock to the U.K. economy that it would deter other countries from following the U.K. to the exit. If the economic impact is more ambiguous, the demonstration effect may be less obvious.

In fact, few economists have backed away from their long-term forecasts that the U.K. economy will be smaller outside the EU than if the country remained inside. Things worked out better than they thought in the short term, for several reasons that don’t change their longer-term expectations.

The momentum going into the June vote was, it turns out, stronger than most forecasts suggested at the time. Growth in the second quarter, over the first, was 0.6%, and inertia alone would likely ensure positive growth in the third quarter.

The biggest thing, says Dean Turner, an economist at UBS Wealth Management, was that the political uncertainty following Prime Minister David Cameron’s resignation announcement was quickly resolved with Theresa May’s appointment. Then, he said, the Bank of England debatably “overdelivered” with a package of measures designed to shore up the economy.

Sterling’s slump also helped manufacturers and retail sales to foreigners in the peak tourist season. Meanwhile, Britain’s largest trading partner—the EU—put in a better economic performance than many economists expected. Consumption, which has sustained growth, also tends to be a lagging indicator. “The mistake that we made in July was that we assumed that consumers were more forward-looking than they are,” Mr. Springford said.

UBS is among a number of forecasters to upgrade its growth outlook. It now expects 2016 growth at 1.9%, compared with 1.3% in the immediate aftermath of the vote. Next year, it forecasts 0.7% growth rather than 0.5%.

“I caution that this is not an optimistic forecast,” said Mr. Turner. “Growth in the second half is going to be much weaker than in the first half of the year.”

In a few months, economists expect the weakness of sterling to boost inflation—because imported goods become more expensive—and eat into people’s spending power: UBS foresees consumer price inflation of 2.5% in 2017, compared with 0.8% this year, and wages won’t rise to compensate. Meanwhile, with business investment expected to weaken given the uncertainty around the terms of Brexit, the labor market is likely to soften, Mr. Turner said, increasing caution among people whose jobs seem less secure.

Longer-term, one almost unvarying law of economics is that trade growth and economic growth go hand in hand. If those pushing a hard Brexit get their way, the U.K. economy is likely to find the EU market harder to penetrate and, at least for some time, will struggle to find other markets to compensate.

That is why most economists still advise against a dramatic break from the EU. If the politics requires that the U.K. leave the bloc, the economics still suggests it should do it gently.