At our most recent Global Macro Committee meeting we discussed the implications of Brexit on global growth and financial markets. Those conclusions are still relevant:
There is no real precedent to rely upon to assess the fall-out for the UK or the global economy more generally as a result of the decision to exit the EU. This, after all, is voluntary and limited to leaving a common market, rather than being forced by markets out of a currency peg. Trade and financial relationships will be disrupted, and the UK, which currently runs deficits in both the fiscal and the current accounts, would need to rely more on internal funding.
More problematic to analyze, the “leave” victory is not a controlled experiment in that it remains unspecified where the nation is leaving to. The UK government will have to negotiate new trade relationships in an uncertain process that might take years. The incentive of EU governments to take a cooperative stance in such negotiations will be limited, to say the least, as they worry about the precedent of voluntary exit. This uncertainty stands as a deadweight loss for risk-taking, both in financial markets and on decisions about capital investment. We will trim our 2016 forecast of UK real GDP growth from 2% to 1% as a result of the exit. This mostly owes to the drag of increased uncertainty on consumption and investment. The UK avoids recession, we believe, because domestic demand, especially from households, provides a floor for growth. On balance, the Bank is likely to leave the door open to an easier stance of monetary policy through dovish communication.
The Federal Reserve, which showed itself sensitive to global economic and financial risks earlier this year, will delay again its anticipated policy tightening until later this year. The depreciation of the pound, poses a particular challenge to the ECB, which exhausted conventional policy accommodation some time ago, as the relative appreciation of the euro will drive inflation rate even further below its goal. The immediate response has been to reaffirm its accommodative policy stance and promise to provide additional liquidity as necessary. Complicating matters for the ECB, though, investors might test other sovereign markets given the precedent that the EU is not inviolable. If strains to become acute, major central banks would presumably use their emergency tools to support large firms and markets.
Aside from some general market strains and potentially large changes in bilateral exchange rates, the direct global economic consequences are likely to be limited. The UK’s share in world GDP stood under 4% last year, and its bilateral trading relationships are mostly regionally diversified and limited in scope. Finance is especially large in its economy, and adjustments within banking organizations to the changed trading regime would be still another drag on an already troubled industry.