HMT, the ‘shock’ of Brexit, and the mix of policy at the zero bound

What we understand to have been so far left out of the HMT Brexit report is the impact of the potential ‘shock’ that a Brexit report would consider.

I sketched suich a shock in an earlier post when I responded to George Osborne’s [mostly] mistaken warning that mortgage rates might rise.

The shock would be something like:  a sharp fall in confidence and demand, prompting rates to rise later than otherwise, or perhaps even fall 0.25 percentage points, and perhaps even a resumption of asset purchases, with the Bank of England’s MPC looking through the short-term boost to inflation that an associated fall in Sterling would imply.  The need to loosen policy would be much greater if the shock were to trigger worries about the ability of our major banks and other intermediaries to fund themselves in the face of a possible capital outflow.

If HMT are worried about such a shock, they might also wonder whether it was wise to set a deficit trajectory so tight that it was appropriate for monetary policy to be so close to the natural floor for interest rates, leaving little room for further cuts to respond.

Either HMT are not that worried about a Brexit shock – hence current fiscal policy is ok – or they are and current fiscal policy is hazardous.  The way to reconcile this is to believe in the power of unconventional monetary policy to substitute entirely, and without other collateral damage [excuse finance pun], to provide extra stimulus.  But I think that the MPC’s revealed response to the disappointments of inflation failing to return to target as quickly as they thought, and indeed some of their explicit statements, show that not even they think of QE and similar policies as effective as that.


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