Time for a policy rethink?

There are few indications as yet that the UK real economy has taken a hit in the wake of the Brexit vote, but the release yesterday of a snap post-referendum consumer sentiment poll does not bode well. The GfK index collapsed by 8 points, the biggest monthly fall in 21 years. It is early days yet and the initial reaction might prove an over reaction. Nonetheless, it will give the Bank of England food for thought as it meets next week to set interest rates.

It really is a toss up as to whether rates are cut in July or August, but either way the Bank looks set to react with a rate cut over the summer as Governor Carney has already hinted. But in a keynote speech last week he pointed out that "monetary policy cannot immediately or fully offset the economic implications of a large, negative shock." Indeed, it is increasingly looking as though the BoE has little real ammunition left to counter the Brexit shock, with the policy rate already at all-time lows on data back to 1694.

I have long been of the view that the BoE missed a trick in not raising rates in 2014 when it became clear that the economy was recovering faster than anticipated and the unemployment rate was falling nicely. In some ways it is understandable that the MPC was hesitant: After all, members did not want to be accused of derailing the upswing which had taken ages to get going. But however sluggish the recovery, the economy was not facing the life-or-death problems which prevailed in 2009. For that reason it was becoming increasingly difficult to argue that interest rates needed to remain at these emergency levels, although perhaps a tight fiscal stance did restrict the BoE's room for manoeuvre.

Some good news is that the BoE has an instrument  which was not available in 2009 in the form of the banks' countercyclical capital buffer, which this week was lowered from 0.5% to 0%. In principle this will raise the lending capacity of the banking system by almost 9% of GDP. But this may not do much good if the private sector does not want to borrow, as BoE officials readily admit.

So the policy cupboard looks a little bare, unless the government does what it should have been doing all along, and relaxes the fiscal stance to take advantage of the lowest bond rates in history - rates which have surprisingly collapsed further after the referendum, with 10 year gilts yields now at less than 1%. The Chancellor has tried to argue over the last 6 years that austerity is the best way to get the economy back on its feet in the long-term. But one thing we perhaps learned from the Brexit vote is that the electorate is not buying that. It may be too late to turn back the referendum vote, but it still isn't too late to have a rethink on fiscal policy. The UK's near term fortunes may depend on it.