Why the UK will need more than rate cuts to offset Brexit shock
Although growth has been less vigorous than in previous recoveries, the UK economy has made real progress since the Lehman-crisis — the private sector has deleveraged, household balance sheets have strengthened and labour market participation has reached a record high.
The near-term Brexit-induced confidence shock promises to reverse some of these positive trends. Uncertainty will reign supreme and weigh on domestic demand until negotiations with the EU begin in earnest.
But if the proper policy levers are pulled, the UK can avoid a recession.
Read more: BoE's Haldane wants "muscular" easing to help economy post-Brexit vote
The Bank of England faces an uphill battle trying to offset the drag from heightened political uncertainty. Any stimulus will therefore need to be big to be effective.
Aggressive monetary easing during periods of heightened uncertainty has several benefits. It helps to suppress financial market volatility, keep the domestic currency competitive, reduce government borrowing costs and ensure that lenders have the available funds to service loan demand.
In a typical easing cycle, the BoE would cut the policy rate by around three percentage points. This time around, headroom for rate cuts is limited. With the bank rate at 0.5 per cent, it will need to look beyond traditional measures to support growth.
As a tried and tested alternative, the BoE should, and probably will, restart its quantitative easing programme. The purchase of, say, £100bn of assets to add to its existing £375bn stock would send a signal to markets, businesses and households that the BoE will take the necessary steps to support a quick recovery.
Post-vote data for household confidence and business sentiment indicates a sharp deterioration in medium-term expectations for growth. A temporary monetary stimulus to lift expectations and underpin a recovery in confidence is therefore warranted. In addition, the UK government ought to look to complement monetary policy with a fiscal stimulus to buffer medium-term demand.
Read more: Pound surges as Bank of England maintains UK interest rate
A shovel-ready public investment programme could offset expected declines in private investment. Given the weak productivity growth in the last decade, some government spending on productivity-augmenting capital is long overdue. A modestly higher public sector deficit would not create significant risks to the UK or its creditors.
Record low gilt yields, despite recent downgrades by rating agencies, illustrates that demand for UK debt is high despite Brexit and the weaker growth outlook. To avert a protracted slump in demand and to prevent a reversal in the positive post-Lehman trends, the UK government should seek to utilise its cheap borrowing costs with a timely fiscal stimulus.