4th July 2016

Post-Brexit Monetary Policy Paradoxes: the new normal

Written by Rebecca Harding, Chief Economist

The Bank of England launches its 2016 Financial Stability Report on the 5th July. Last December’s report told a story of the UK emerging from the financial crisis. The focus was on stability rather than risk with an emphasis on buy-to-let as a domestic economic risk and emerging market growth as the main headwind externally faced by the UK. The confidence of the Bank was such that its report considered a “counter-cyclical capital buffer” but kept that buffer at 0% because of potential liquidity challenges in some core financial markets, for example from the collapse in oil prices and the devaluation of the Yuan in the summer last year. The Bank announced plans to increase this buffer to 0.5% in March 2017 and tomorrow’s report will give an interesting indication of whether or not it intends to take this forward or reverse course.

In contrast now, since the UK referendum and decision to leave the EU on the 23rd June, the Bank of England has injected £3.1 billion into UK banks to support them during a period of uncertainty and inevitable market volatility. Its contingency plan was originally £250 billion and there is more money available should the need arise. This is done to protect the UK economy against loss of bank liquidity and highlights how much more prepared central banks generally are than they were in 2008. Indeed, measures of volatility appear to have stabilised in the US suggesting that the interventions have worked, at least in the short term.

rhgraph

Source: CBOE

Much of the talk, post-referendum has been about bank location rather than liquidity, perhaps because the measures that the Bank of England has taken to stabilise markets has hidden this core issue. However, short term special liquidity measures are not a permanent fix. The direction of monetary policy now is more important to banks, arguably, simply because it determines the stability and profitability of their markets longer term. Even before Brexit, the direction of base rates and the future of Quantitative Easing (QE) was not clear; perhaps Brexit sharpens the lens slightly.

First, the UK’s credit rating has been downgraded, potentially making UK debt appear more risky and pushing up yields. Given that the immediate post-Referendum fall out was a drop in UK 10 year Gilts, this may seem welcome. However, this simply creates a paradox for the Bank: on one level, it may create some inflationary pressure and, hence, give the Monetary Policy Committee a reason to increase interest rates more broadly. But equally likely is that there is less investment at higher rates which actually puts downward pressure on interest rates.

Second, given the fragility of UK GDP growth before the Brexit vote, Bank of England Governor Mark Carney last week pledged that the Bank would do whatever it takes to ensure stability, which will most likely involve a cut in interest rates, and possibly other forms of monetary policy easing as early as the next Monetary Policy Committee meeting on 14th July. Most forecasts for the UK economy suggested a mild pick-up in UK GDP growth in the second half of the year once the referendum had taken place and “business as usual” had been restored. Given the outcome of the referendum, “business as usual” is unlikely. No-one knows exactly how the effects will work through the system but the probability is that business investment will be held back until the structures of any new arrangements on access to the Single Market and Free Trade with the European Union have been agreed.

As a corollary, there is evidence in lending data that that even before the Brexit vote, consumers were not confident. Unsecured personal lending, particularly in the form of credit cards and overdrafts can be viewed as emergency borrowing to cover income shortfalls. And while some of this may be to take advantage of low interest rates, the fact that it has been increasing sharply suggests a deeper problem for monetary policy makers: while rates remain low, this remains affordable, but as soon as interest rates rise, so too does the level of distressed debt.

rhgraph2

Source: BBA, Bank of England

Third, the value of Sterling dropped sharply in the immediate aftermath of the vote and although it corrected upwards subsequently it has fallen sharply since its pre-referendum level. This also presents monetary policy makers with a conundrum: if interest rates remain low, or are even reduced, then this continues the downward pressure on Sterling which is a help for UK exporters. However, a low value of Sterling pushes up inflation through higher import prices and puts upward pressure on rates.

Finally, the UK’s monetary policy does not operate in a national vacuum: the Fed and the ECB stand ready to support bank liquidity if volatility increases but the strength of the Dollar compared to both the Euro and Sterling gives other central banks a challenge too. The US has been on a path towards steady increases in of rates, but central bankers do not want to see the Dollar dominance of last year; and any further injection of liquidity by the ECB may yet push the Euro lower. Similarly the Bank of Japan may need to react to the strength of the Yen. Avoiding a global financial crisis means global monetary policy – that is the legacy of 2008.

Monetary policy is increasingly paradoxical but it is likely that the next move that the Bank of England takes will be down rather than up and that more quantitative easing may be on the cards. All eyes will be on the Financial Stability Report this week for evidence of any nervousness about the underlying weakness in the UK economy and any mitigating action to maintain market stability. The full market consequences of the vote have not yet worked through and the MPC is likely to wait to move unless the Financial Stability Report suggests otherwise.

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