NIESR: Monetary and fiscal options in the event of a ‘No-Deal’ Brexit

18 Jul 2019 10:50 AM

In the Commentary of the August 2019 National Institute Economic Review (no 249), due to be published next week, NIESR’s Director Jagjit Chadha outlined the economic shock of a ‘No-Deal Brexit’ and the responses available to monetary and fiscal policy in that scenario to smooth the path of output.

Prof Chadha yesterday said:

“We estimate that the negative shock on impact, without accounting for any policy response, may be in the region of some 2-3 per cent of GDP, around one third of the size of the financial shock that triggered the financial crisis. But policymakers have room to inject monetary and fiscal stimulus to stabilise output. Monetary policy has some room to respond if inflation expectations and labour costs are anchored (and also thought to be anchored by policymakers) at a level that is consistent with the medium-term 2 per cent inflation target. And if fiscal responses are adjusted to allow for higher government spending, which implies a looser interpretation of the ‘fiscal rules’, some of the effects of an abrupt exit from the EU can be mitigated.”

The long-run assumptions underlying our No-Deal scenario are laid out in detail in a previous NIESR report. The Institute assumed that goods trade with the EU will be 50 per cent smaller compared to continued EU membership, services trade would be 65 per cent smaller and foreign direct investment will be 24 per cent lower leading to overall business investment being 3.5 per cent lower. We further assumed that net migration halves and the combination of lower investment, reduced levels of international competition and the potential lack of skilled labour from abroad reduce productivity by some 1.5 per cent in the long run compared to continued EU membership.

Prof Chadha yesterday continued:

“The response of monetary policy will depend on the magnitude and direction of aggregate demand and supply shocks. If mostly the former and negative, then monetary policy can respond by lowering Bank Rate, signalling limited scope for a return in rates to some neutral level for an extended period, as well as sanctioning more asset purchases as well as support for commercial bank lending.  To the extent that manipulations of the path of Bank Rate and operations on risk premia may not be sufficient, given that Bank Rate is so near to the zero-lower bound, there is a case for some countercyclical fiscal policy as well, in which case aspects of the Chancellor’s fiscal rules may need to be relaxed.”

“It gets more complicated if we get both types of shocks. There has been evidence to suggest that demand will also be affected. We can expect uncertainty to become chronic and business investment to be deferred in line with both lower future economic activity but also in proportion to the level of that uncertainty. There is some evidence to suggest that inward FDI has stalled somewhat as well. We might also expect some fall in net exports. The impact on investment and net trade alone will tend to reduce inflationary pressure.  In which case, both arms of monetary and fiscal policy will have a job to do in order to stabilise demand by loosening monetary and financial conditions.”

Prof Chadha concluded:

“While leading to a somewhat smoother adjustment, expansionary monetary and fiscal policy measures would not come without a longer-term cost. As a result of looser borrowing conditions, the risk of asset price inflation rises and levels of private and public debt would increase further from currently elevated levels. At the end of this response, we are then likely to have an economy that is more vulnerable to financial shocks and may reduce the space available to monetary and fiscal policy to react to shocks unrelated to the question of EU exit.”

Notes for editors:

“Monetary and fiscal options in the event of a ‘No-Deal’ Brexit” will be published in the National Institute Economic Review No. 249 August 2019.

This journal is a quarterly, peer reviewed, economic and social sciences journal. The full Review is published from midnight on Wednesday 24 July.

For further quotes from  the author please contact the NIESR Press Office:

Paola Buonadonna on 020 7654 1923 / p.buonadonna@niesr.ac.uk  

Further reading: Hantzsche, A., Kara, A. and Young, G. (2018), The economic effects of the government’s proposed Brexit deal, NIESR report, November 2018, also published in The World Economy, 42(1), pp. 5–20.

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