Britain’s economy after the vote to leave the European Union has been marked by one word: uncertainty. However, the FTSE 100, the UK’s main stock index, seems to be ticking along nicely. Having quickly rebounded after the initial shock of Brexit caused a 3.15% drop, it rose a further 1.6% when the Bank of England cut the interest rate to a historic low of 0.25% to counterbalance the potential negative effects of Brexit on the UK economy.
A stock market rise was the expected result of the announcement and research has shown how interdependent interest rate moves and stock prices are. Lower interest rates generally lead to an increase in share prices because they make bonds less attractive and decrease the cost of borrowing for new investments.
The drop in the pound, which decreases costs for multinational UK companies, will also have buoyed the FTSE. In addition, the Bank of England’s pledge to implement more quantitative easing involves buying corporate bonds to help reduce the cost of capital of UK corporations and increase profits.
However, this data refers to the short-term reaction of the stock market. The long-term consequences strongly depend on whether it is believed that the interest rate cut will improve the economic outlook of the UK. This does not look promising.
A few problems ahead
Banks can be reluctant to lend in periods of uncertainty, as economists Atif Mian and Amir Sufi point out in their book House of Debt. This could limit the extent to which banks pass the benefits of the interest rate cut onto consumers. In addition, households themselves may not want to borrow more because of the uncertainty brought on by Brexit. An interest rate cut of a mere 0.25% may not be enough to convince banks to lend more and households to borrow more.
Another problem to consider is that although interest rates have hit record lows, they were already very low, at 0.5% since March 2009. This means that there is now little room for monetary policy to influence economic activity further. This condition, commonly known as the “zero lower bound”, suggests that a further interest rate cut, which has been hinted at, may fall short of improving the economic outlook. The fact that the Bank of England’s governor, Mark Carney, is reluctant to push interest rates below zero reflects the fact that monetary policy has very limited power left to stimulate the economy.
The impact of quantitative easing (QE) programme could also turn out to be moot, as it may simply inflate asset prices without stimulating consumption. The QE effect usually affects high net worth individuals, who represent a relatively small proportion of UK households and whose propensity to consume is not affected by uncertainty as much as those who are less well-off. This happens because the proportion of income that poorer households spend on essential items (food, clothing, accommodation) is much higher than for wealthy households.
Good news hiding the bad?
If and when more of the same economic medicine fails to work, it may be necessary to use “helicopter money”. Rather than lowering interest rates, the government could bypass banks and directly inject cash into the economy, thereby increasing the likelihood that it would be used to improve consumption and aggregate demand – exactly what is needed in the UK right now.
Of course, this does not mean that we should expect helicopters to drop banknotes over crowds in Trafalgar Square. However, the government could, among other alternatives, increase salaries for government employees, or decide to invest in key infrastructure projects. At the moment, despite the support of some economists, it is unclear whether the government is willing to undertake such an innovative strategy.
In my view, however, it is the reluctance of the UK government to trigger Article 50, which officially begins Brexit proceedings that should be of major concern. In recent research, I found just how reluctant people in charge are to release bad news.
An investigation of dividend announcements in more than 1,500 US companies between 1971 to 2014 suggested that the majority of firms would announce increases in the dividend per share (good news) early, while announcements of dividend cuts (bad news) tended to be delayed.
The suggestion that the government may wait until 2019 before triggering Article 50 indicates that it is trying to buy as much time as possible before delivering some very bad news to the British public when it comes to the economy’s performance. The delay suggests it is unlikely that the government believes the interest rate cut will be enough to offset the potential negative impact of Brexit.
What the stock market tells us about the British economy post-Brexit is republished with permission from The Conversation