Uncertainty has gripped financial markets in the UK and around the world. The immediate response has been unprecedented. In the space of six hours sterling has fallen are 10 per cent against the dollar to the lowest level for 31 years. Stock market futures indicate that the equity markets will fall by around 10%. Further gyrations are expected over the coming days and weeks as market participants grapple with the implications of the results. The response so far reflects a weaker expected economic outlook.
The key area to watch will be the interbank markets. In these markets banks lend excess reserves to each other on a short term and unsecured basis. In periods of uncertainty, the amount of money being committed reflects how banks perceive the credit worthiness of each other. If they consider some counterparts to be weakened significantly, they may stop lending and then the turmoil would become a crisis. The Bank of England has been very vigilant to this possibility and made sure that institutions have enough reserves for the short term. The longer the market volatility continues, the more reserves will be required. We expect the Bank of England and other central banks will stand ready to meet these needs to prevent any escalation.
The fall in the value of sterling will also lead to higher inflation. The combination of higher inflation and weaker economic growth creates a quandary for the Bank of England when setting monetary policy. If they raise interest rates in response to the expected rise in inflation this may worsen the expected economic downturn. Given the financial risks and the Bank’s already cautious outlook for the economy, it is most likely that they will not raise interest rates. Indeed, they may even act to provide more stimulus by either lowering interest rates or enacting more quantitative easing. The most likely course of events is to hold policy stable in the near term.
The Chancellor suggested that there would be an emergency budget if the UK leaves the EU. If the economy responds as economists have predicted, then the fiscal position of the government will worsen. This will require a combination of higher taxes and lower spending to correct the impact. However, timing is critical. Until the direction of the economy is clear, it is unlikely that there will be significant fiscal policy changes in the short term. Over the longer term, the direction of adjustment will be toward further fiscal tightening if the government is to return the budget back to balance.
Credit rating agencies have indicated that UK government debt will be downgraded. If Northern Ireland and Scotland look likely to have independence referendums, there may be further credit downgrades to follow. Credit downgrades lead to higher borrowing costs. However, there are conflicting forces determining whether total borrowing costs will rise: on the one hand, the weaker expected economic outlook will lead to lower borrowing costs; but the credit downgrades will lead to higher borrowing costs. The actual outcome depends on which is greater. Overall, the net impact on government actual borrowing costs is likely to be modest.
The government borrowing costs tends to put a ‘floor’ under the borrowing costs of banks. The credit ratings and borrowing costs of banks may worsen. However, mortgage rates mostly depend on shorter term interest rates (for tracker and short term fixed rate mortgages). If the Bank of England does not change the policy rate, it is unlikely that mortgage rates will rise significantly.
By Angus Armstrong, senior fellow at The UK in a Changing Europe
The views expressed in this analysis post are those of the authors and not necessarily those of the UK in a Changing Europe initiative.