from Macro and Markets

Britain’s Bold Leap into the Unknown

June 24, 2016

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Britain’s vote to leave the European Union was fueled by a broad range of social and political concerns, including a fear of immigration, resurgent nationalism, and a populist rejection of UK and European policies, institutions and policymakers. But is also an extraordinary economic experiment. Here are a few things to look for in coming days as the global economy tries to absorb the implications of this leap into the unknown.

A sharp market jolt, followed by extreme volatility

Pound sterling was in the vanguard of the market reaction. After reaching 1.50 against the dollar yesterday on hopes of a remain vote, the pound fell to 1.33 before rebounding to 1.37. Global equity markets also have fallen sharply this morning, partly a reflection of how unexpected the result was and partly a natural pulling back in risk taking in the face of uncertainty. The biggest falls were outside the UK, in Europe and Asia, and U.S. futures predict a significant decline here.

It is often noted that, initially, little changes in the fundamentals of the British economy. It could be several months before Article 50 of the EU treaty is invoked by a new British prime minister, beginning the formal process of withdrawal that would take at least two years, and likely more. For now, the way Britain moves, works and trades will not change. Still, the uncertainty about what follows, and the potentially protracted political debate that follows, is likely to contribute to an elevated level of market volatility. Weaker levels for the pound, and equities, seems more likely than not.

Central banks show the flag

The Bank of England quickly announced its commitment to “take all necessary steps to meet its responsibilities for monetary and financial stability” and indicated that it had provided significant amounts of dollar and pound liquidity. A number of other central banks have confirmed intervention, and globally this shock likely will be a reason for monetary policies to remain accommodative in coming months. As it has been in this recovery, the burden of driving economic recovery falls fully on central banks.

Aggressive central bank action can go a long way to addressing liquidity concerns in markets, but what it can’t do is fix underlying concerns about the health of the European financial system. We should be worried about what a shock to growth, and the asset price moves we are seeing, mean for the longer-term viability of European banks that are already struggling to achieve profitability and deal with the legacy problems from the earlier crisis. Concerns about specific financial institutions in the UK and Europe could emerge in coming days and perhaps represents the bigger threat to market stability.

A UK economic stall, which will be felt globally.

Market analysts predict a sharp fall in UK growth over the next year, on the order of 1-2 percent lower, with some predicting an outright recession. At the same time, the rating agencies have signaled that they are likely to downgrade the UK. Uncertainty will be felt on investment most importantly, as well as consumer sentiment. Even if you are optimistic about the long-run future of the British economy outside the EU, the cyclical effects appear likely to be significant. The shock will drag European growth lower, adding to political strains on the union. I expect Grexit will again return to the front pages of the newspapers, along with calls for referendum elsewhere.

A drag for the Fed

The fallout from the Brexit vote in the United States--tighter financial conditions caused by weaker stock markets and reduced risk taking, uncertainty about the future of Europe and global trade, as well as a weaker outlook for growth, strengthens the case for the Fed to put off rate hikes (if they needed any reason beforehand). Many issues that have come to the fore in our election campaign, including anxiety about the economic future of the country and globalization, will get a new look today. Together, there are many reasons to believe the economic consequences for the United States could be significant. Again, Britain punches above its weight.

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