Brexit: Regime Uncertainty At The Zero Lower Bound

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Includes: ADRU, DBEU, DBEZ, DBUK, DEZU, DXPS, EEA, EPV, EURL, EWU, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEE, FIEU, FKU, FXB, GBB, GSEU, HEDJ, HEWU, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, PTEU, QGBR, RFEU, SBEU, UPV, VGK
by: Lars Christensen

Brexit is on everybody's mind and even before the - for the markets - surprising "Leave" vote on Thursday, the British EU referendum was the dominating theme in the markets for awhile. When the news came out early Friday morning, the global financial markets reacted strongly.

That is the kind of reaction we are used to when we have a major "risk off" shock - stock markets drop sharply, the yield curve flattens, market inflation expectations drop, the pound weakens significantly and the dollar strengthens.

However, the question is what kind of shock it really is. The answer is that the Brexit shock initially is a supply shock that turns into a demand shock. I will try to explain that in this post.

Increased "regime uncertainty" is initially a supply shock

The fact that the Brits voted to leave the EU, in my view, best can be described as what Robert Higgs called "regime uncertainty". A shock that increases regime uncertainty is essentially a shock that increases uncertainty about the overall institutional framework in the economy - in this case: Will the UK be a member of the EU's single market in the future? What will Brexit mean to the free movement of labour in Europe? Will UK banks be able to operate freely as before in other EU countries, etc.?

This is the regime uncertainty regarding the UK economy, but equally, we have increased regime uncertainty within the EU. Will this for example lead to other countries leaving? Will this cause the "new" to drift in a more interventionist direction? Will this make it harder to get reforms through?

Essentially, such regime uncertainty is a negative supply shock that should cause real GDP (growth) to drop in both the EU and the UK and cause an increase in inflation.

This in itself is bad enough but the historical experience shows that such shocks rarely have major impact and are of a relatively short-lived character and most observers of the situation likely would also agree that the EU and the UK will have a common interest in finding a solution that overall keeps the UK as part of the EU's single market, and realistically, then it would not be unreasonable to assume that the overall level of tariffs and trade barriers in the UK and the EU will not be much changed in 5-10 years time.

So yes, Brexit has increased regime uncertainty, but on its own it shouldn't be a matter that significantly should change the medium-term outlook for the EU and the UK economies.

The monetary shock is the most important shock

So while we have seen an increase in regime uncertainty, I believe a more important factor is what is happening to monetary conditions as a second order effect of the increase in regime uncertainty.

First of all, it is clear that Brexit has caused an increase in particular demand for US dollar and other safe assets. This is essentially a precautionary increase in money demand and for a given money base this a passive tightening of monetary conditions.

Secondly in my view, more importantly, the increase in regime uncertainty should basically be seen as a drop in the expected trend growth rate in both the UK and the eurozone. This means that we should expect the natural interest rate to drop both in the UK and in the eurozone and maybe even globally.

Given that both the Bank of England, the ECB and the Federal Reserve are targeting interest rates (using them as a policy instrument rather than using the money base) and that all three central banks have interest rates close to the Zero Lower Bound (ZLB), a drop in the natural interest rate (caused by a negative supply shock) will cause an increase in the difference between the policy rate(s) and the natural interest rate(s), which effectively is a tightening of monetary conditions.

This would not be a problem if interest rates where significantly above the ZLB, as markets then just would expect central banks to cut rates. Similarly, it wouldn't be a problem - even at the ZLB - if central banks were using the money base as a policy instrument as that would mean the central bank always would be able to ease monetary policy.

Unfortunately, both the ECB and the Federal Reserve do not seem overly eager to restart/step up quantitative easing. As such, they have mentally committed themselves to a "liquidity trap", which means that negative supply shocks automatically also turn into negative demand shocks.

It wouldn't have to be this way and the Bank of England, which the markets clear perceive to be more willing to step up quantitative easing if necessary, in fact, provides a good example of this. Hence, while inflation expectations have dropped both in the eurozone and the US, the opposite is the case in the UK where inflation expectations actually has to increase - and has been more or less flat over the past month. This clearly indicates that the markets expect the BoE to try to offset the negative shock from Brexit by easing monetary conditions. This by the way also give some reason to be optimistic about the macroeconomic impact of Brexit even in the near term.

BEI UK EZ

In this regard, it is also notable that we have seen a sharper increase in the Credit Default Swap (CDS) on Italy than on the UK CDS on the back of Brexit. Said in another way, Brexit is hitting the eurozone harder than the UK.

Why is that? To me, the difference is that the UK has a floating exchange rate and a central bank willing to offset negative shocks, while Italy or other eurozone countries do not have an independent monetary policy to offset the shock from Brexit and the ECB likely also is less willing to ease monetary policy than the Bank of England is.

So once again - blame the ECB

Yes, I know - it is Lars' Law: Always blame the ECB. But I can't help myself. It is clear to me that had the ECB been committed to at least hitting its inflation target and the markets had seen this target as credible, supply shock in the form of increased regime uncertainty would have had a much smaller negative impact than presently seems to be the case.

It is the failure of not only the ECB, but also of the Federal Reserve to ensure nominal stability and well-anchored inflation expectations that is magnifying this crisis.

There are worse things than Brexit

Finally, I would like to note that even though distress has increased in the global financial markets since Thursday, there is no reason to panic over this "event" on its own. Had we had credible inflation targeting or even better, nominal GDP targeting central banks in Europe and the US, then this would not be a big deal even for the global economy.

In fact, even taking into account the lack of credibility of the Fed and the ECB the market reaction might not have been quite a big as some (like my friends Scott Sumner and David Beckworth) seem to believe. Hence, if we look at for example the global stock markets, there are little changes over the past 1-2 weeks. The same goes for the dollar and the global commodity markets. And most importantly, even though the shock has caused inflation expectations to drop - the drop has not in any way been major.

Therefore, I actually believe that the focus should not really be on Brexit in itself. Rather, I think it is much more worrying that the Federal Reserve has been overly eager to hike interest rates and, as a consequence, US inflation expectations have continued to decline since 2014.

Obviously, as I discussed above, these issues are linked in since the continued de-anchoring of inflation expectations both in the US and the eurozone increase the risk that any shock will be significantly amplified by lack of monetary policy credibility.

Therefore, it is of utmost importance that both the Fed and the ECB ensure nominal stability. That would mean a much stronger commitment to anchoring inflation expectations at 2% and a clear announcement that both central banks will increase money base growth if necessary to ensure their nominal targets. Unfortunately, we have yet to see such commitment.