Brexit repercussions will weigh heavily on the British economy

Posted by pt91 at Jun 24, 2016 10:45 AM |
Professor Panicos Demetriades gives his initial reaction to the Brexit vote

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As I have been saying over the past few weeks and months, a vote in favour of Brexit will unleash unprecedented political and economic uncertainty, not only in the UK but also throughout Europe, which will weigh heavily on the British economy and the value of sterling.  All this is already happening and it will be several months before negotiations for a new deal with the EU can even start, as a new government will now need to be formed.

We are already witnessing unprecedented volatility in financial markets, as indeed many economists predicted. The value of sterling has plummeted and this will have an almost immediate impact on most people in the country

It remains to be seen how the Bank of England will react.  The Bank faces some very difficult trade-offs.  Economic and political uncertainty will weigh heavily on the economy and will push the economy towards recession.  To counter those tendencies, the Bank will need to lower interest rates and to extend its QE programme.  On the other hand, the Bank may need to defend the value of the pound in order to reduce inflationary pressures, which would require raising rates and pursuing a tighter monetary policy.  The latter has significant implications for financial stability as higher interest rates will impact on borrowers’ ability to repay mortgages and other loans, which, in turn has implications for banks’ solvency and the property market.

The Bank may, of course, choose to wait and see, supporting the banking system with liquidity as and when needed without changing rates.  To me, the latter option, seems the most reasonable one, as raising interest rates now could actually send the UK economy into recession.  As inflation is well below target, the Bank has some leeway before deciding whether an interest rate hike is needed.  Indeed, sterling may well start recovering once uncertainty begins to be reduced.

Mark Carney’s statement this morning indicates that the Bank is very concerned with market volatility and capital outflows.  Although he tried to be reassuring, suggesting that the banks are well capitalised and stress-tested to withstand even bigger shocks than we witnessed yesterday, the need to make that statement could be perceived as suggesting that the banking system may already be facing liquidity pressures.  In these sorts of situations, even a reassuring statement by a central bank governor can have unintended consequences.

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