The citizens of the United Kingdom decided on a new path by rejecting the referendum to remain in the European Union. Where their winding path ends will not be known for some time. In the very near term, we need to ask:
Market functioning is an issue as capital devoted to trading has been declining since the crisis, and the banks housed in London, uncertain about their future, will be conservative about their capital. More generally, any time that important asset prices move sharply, we risk learning something about someone’s balance sheet. We do not know who or what. That said, the release of the Fed stress yesterday afternoon was helpful. Assessed against a tough economic and market scenario and graded harshly by supervisors, the Fed found that all 33 banks retained a capital buffer when a very bad thing happened.
As for policies in advanced economies, the problem for the world is that an adverse demand shock cannot be offset by two of the major nodes of the financial system, as the European Central Bank and the Bank of Japan are pinned to their effective lower bound. With marked pressures on the British pound and the Fed less likely to tighten, appreciation of the euro and yen represents an unwelcome tightening of financial conditions.
As for emerging markets, appreciation of the dollar poses an equally unwelcome quandary: either continue to keep the currency stable vis-à-vis the dollar and tolerate appreciation relative to a basket of currencies or let local currencies slip. If the latter, the tactical problem is limiting the slip, recognizing that the record is discouraging. Chances are that this will be viewed as the least-worst option, as tolerating appreciation reduces activity domestically and intensifies the headwinds on global activity.
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