Independence Day: The Broader Consequences of the UK Referendum

The most apt description of political events unfolding in the United Kingdom after the decision of voters there to leave the European Union came from Nicola Sturgeon, first minister for Scotland. “Shambolic,” she said.1 The minister, herself, stirred the pot by raising the specter of a second Scottish independence referendum before the last hanging chad had fallen on the “Brexit” vote. If handicapping the horserace for the prime minister, let alone the strategic negotiations among 28 governments required to extricate the UK from the EU seems daunting, assessing the consequences for the wider world is downright hopeless. But doing so is necessary to have a coherent view of the outlook for the global economy and financial markets.

This note sketches the bigger picture, and it is not pretty.

The broad-brush version is that the UK inflicted an adverse aggregate demand shock on itself. Depreciation of the exchange value of the pound and a drop in gilt yields was the market mechanism to blunt the force of the shock. In effect, the appreciation of the currencies of the UK’s trading partners represents a request from Her Majesty’s economy to share some of their economic strength. The problem is that for many of them there is not much strength to share and, for a few key ones (the Euro area, Japan, the Nordic economies, and Switzerland) their central banks have mostly run out of room to provide policy accommodation to offset the drag from appreciated currencies. The cruel irony is that, as a result, their exchange rates may appreciate relatively more on recognition that disinflation and higher real interest rates are in store.

Monetary policy makers will respond, but gathering the courage to scale unconventional policies up will take them time and their efforts most likely will be insufficient to the task. As a result, the aggregate demand downdraft in the UK represents a net drag for the world. While the direction seems clear, size is another question.

Given that there will be some policy offset, we believe the net effect should be small, so mark down your 2016 forecasts for real GDP growth in the UK about 1 percentage point and for the world ¼ percentage point. While the US Federal Reserve does not have much policy space above the effective lower bound to nominal rates, pricing out tightening is enough stimulus to offset this external drag. As a result, we are not trimming our 2016 outlook for growth, which was already on the low side at 1.6 percent for the year, at least until the payroll numbers are in hand.

Emerging market economies face three challenges. Weaker growth in advanced economies slows the expansion of their export markets. Appreciation of the dollar tends to soften commodity prices, which is problematic for producers. And those economies tending to limit the fluctuations of their currencies vis-à-vis the dollar will see their exchange rates appreciate. Softening the competitive blow for Asian EM economies, though, the Japanese yen rose more than the dollar against the UK pound. 

What follows revolves around three questions relevant to the medium-term economic outlook.

  • Why did the referendum result in an adverse demand shock in the UK?
  • How is that shock propagated?
  • Where will that shock pose particular risk?

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