Ever since the financial crisis we’ve become accustomed to the idea that whatever governments fail to do, central banks can always come to the rescue. If you need a reminder of why this statement is wrong, look no further than the Bank of England.
Much like other monetary authorities in the rich world, the BoE has been the main driver of the UK recovery after the crisis. Ultra-low interest rates and asset purchases have helped to restore a healthy flow of credit to the economy. This gave banks the space to strengthen their balance-sheets, ensuring they are better prepared to weather a new crisis.
And then came Brexit. It was always clear that the UK decision to leave the EU would cause some short-term damage to the economy. Companies would put investment on hold as they waited for the uncertainty over the future trading status between Britain the EU to disappear. The pound would weaken, making imports more expensive for consumers and impacting spending.
There is now a growing risk that the economic damage could be even more severe. The UK government is struggling to put together a coherent plan on how to leave the EU, much less one that is also acceptable to its partners. This makes it more likely there will be a cliff-edge Brexit, whereby the UK is immediately cut off from its largest trading and regulatory partner without a deal.
Unlike during the last recession, there is little the BoE can do to restore growth in this scenario. Governor Mark Carney can warn UK politicians of the consequences of Brexit, as he has done on multiple occasions. The bank can also revise downward its forecasts for the maximum speed at which the UK can grow without generating inflation--as it did in the last inflation report.
But whatever the government chooses to do, the bank simply has to live with it.
The BoE will need to go back to the old textbook description of central banking. Ultimately, its primary objective is to preserve financial and monetary stability, defined as keeping inflation at 2 per cent over the medium term. This means limiting the economic damage from a Brexit, particularly if negotiations were indeed to collapse and Britain to walk away without a deal.
The bank has three levers to pull: the first is mainly advisory. There is a huge amount of financial plumbing underneath the English Channel, which would be seriously disrupted in the event of a disorderly Brexit. Some clauses in a wide range of financial contracts - from derivatives to bank bonds - would be harder to enforce in the absence of a cooperation agreement.
The bank and its EU counterparts must start to prepare now to avoid regulatory mayhem.
The second is monetary policy. The bank chose to raise interest rates as it felt the economy is getting close to its full potential. The Monetary Policy Committee could have waited a bit longer: Inflation is running above the 2 per cent target, but is expected to come down in the coming months.
What the MPC has done, however, is to warn the public and investors that they should not assume interest rates would fall in the event of a slowdown. As Carney said, a bad Brexit deal may well prevent the bank from loosening monetary policy.
Finally, the bank must watch lenders like a hawk to ensure they are strong enough to withstand a crisis. At the end of November, the supervisor will present the results of its stress tests on UK banks. One scenario mimics some of the shocks which would take place in the event of a cliff-hang Brexit, such as a steep fall in the value of the pound.
The bank has recently been quite lenient in its capital demands, attracting criticisms from John Vickers, the chief architect behind the UK’s post-crisis banking reforms. Some would argue it is best not to press too hard on lenders, as this could hamper growth.
However, in the event of a bad Brexit growth would come to a halt anyway. Meanwhile, a run on UK assets could provide a serious shock to the banking system. The best the BoE can do at this juncture is to prepare the financial system for the worse--and hope it does not happen.
The UK is in a particularly tough spot, but its experience holds lessons for governments around the world. Central banks and regulators can help to boost growth but their priority has to be preserving price and financial stability. Politicians are ultimately responsible for the mistakes they make.
