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The Bank of England (BoE) would not be able to cut interest rates in case Britain exits the European Union because a likely run on the currency resulting from the move would push up inflation and bind the central bank's hands, said Adam Posen, president of the Peterson Institute for International Economics.
Posen, a former member of the BoE's Monetary Policy Committee (MPC), said the central bank might in fact have to tighten monetary policy to prevent capital from fleeing the country too quickly. That runs against the expectations of some market participants, who believe the BoE might ride to the rescue in case of a "Brexit."
Britain will hold a referendum on breaking with the European Union on June 23. "If there is a vote for Brexit, I would expect a pseudo-sterling crisis," he said. "Not a full-on sterling crisis of the 1970s sort, but pretty darn bad."
Investments in the United Kingdom would be dumped or postponed due to increased uncertainty, a pattern that is already evident in a recent weakening of the economic data, said Posen.
In addition, "the value of sterling will drop, largely because we would expect larger trade deficits and export troubles, and the expected average volatility of sterling exchange rates will be higher going forward."
The result? "There would be a large drop in output for a protracted period and a substantial decline in sterling," Posen said. "That would in the short term look like stagflation with the initial inflation. The likely outcome over more than a few months, though, would be an increase in interest rates by the Bank of England to resist the capital outflow and decline in the pound, fearing the impact on inflation, so you get just the recession but not ongoing upwards inflation."
The Bank of England has held interest rates at a record low of 0.5 percent since 2009 and engaged in substantial asset purchases like those conducted by the US Federal Reserve in response to the Great Recession of 2007–09, aimed at keeping long-term borrowing costs down.
Posen supported these moves and sometimes argued for even more aggressive action. But a Brexit scenario would turn things around.
"The size of the sterling shock, combined with the uncertainty about the future path of UK trade deficits and domestic investment, will be too large for the MPC to ignore. The MPC will not be able to count on it being a one-time shock that can just be ignored," said Posen. "I was proven right when I argued that with regard to inflation upticks during my time on the MPC, but as I said at that time, I was calm because of the environment, not because I didn't care about inflation," he added. "The environment will not be so conducive to stable inflation expectations or low pass-through from exchange rate to inflation after Brexit."
In addition to hitting the pound, denting investment prospects, and pushing up inflation, a Brexit would also damage the UK economy's longer-run capacity for growth, again limiting room for monetary stimulus to respond to weak growth or contraction.
"Brexit would rightly be seen as diminishing UK growth going forward for at least several years, if not permanently," said Posen. "While the initial impact of that on the forecast would be disinflationary, I believe that would be more than offset by the decline in potential growth. And a lower trend of potential growth with lower labor supply would be more inflationary at any given rate of growth."
