How Central Banks Could Benefit From A “Protectionist-Driven” Global Downturn

How Central Banks Could Benefit From A “Protectionist-Driven” Global Downturn Authored by Steven Guiness, via ZeroHedge

From observing the behaviour of ‘leavers‘ and ‘remainers‘ since the EU referendum in 2016, I have seen first hand how partisanship works as an effective tool to cloud judgement. Once a position of bias becomes ingrained, it has proved next to impossible to see beyond it or for the individual concerned to be convinced of an alternative perspective.

The psychological operation of ‘fake news‘ is now entrenched within society, with both sides of the divide claiming one another to be peddlers of false truths. By my reckoning this is all the more reason why positioning yourself as neither one thing or the other is the only logical way in which facts can be objectively scrutinised.

The role of the Bank of England in the Brexit process is an example of how bias is serving to insulate central banks from impartial and informed criticism. On one side are those who depict governor Mark Carney as an ‘enemy‘ of Brexit, whilst on the other are people who consider Carney as a safe pair of hands amidst a whirlwind of political turmoil. Non-partisan analysis of communications and policy decisions emanating from the BOE is rarely given space to evolve.

For instance, last week the bank published its latest Financial Stability Report in conjunction with a press conference delivered by Mark Carney. Whilst much of his interaction with the press on Brexit was of a similar theme to previous events, one aspect in particular stood out.

Asked by Joel Hills of ITV News about the level of preparation in the event of a no deal Brexit, Carney affirmed that the financial system in which the BOE presides over was ‘ready for whatever form Brexit takes.’ Carney’s conviction stems from a series of bank stress tests that the BOE conducted in 2018 in an attempt to gauge how the financial system would stand up to a crisis greater than 2008. The results as published by the BOE showed that the UK’s banking system was fully prepared.

Indeed, Carney’s confidence was such that he went on to say how the system would continue serving both households and businesses, ‘even if a worst case disorderly Brexit occurred at the same time as a global slowdown triggered by a trade war.’

Where it started to get more interesting is when Carney made an unequivocal distinction between financial stability and that of market and economic stability. The area where the BOE possess overarching control – the financial system – is, according to the bank, prepared for any adverse scenario. But this preparation does not extended to currency or equity markets, nor economic fundamentals such as inflation which would likely become volatile should supply chains into and out of the UK be compromised.

To quote Carney exactly, ‘market stability will adjust potentially quite substantially if there is a no deal Brexit. Even with a smooth adjustment this would still be a major economic adjustment and major economic shock – in not just a short period of time but virtually instantaneously.’

The expectation from the BOE is for immediate volatility if and when a no deal exit is confirmed. Not from within the financial system itself, but within the surrounding economic environment. The areas which the bank purport not to have direct jurisdiction over. Those who keep abreast of Brexit led developments will know that the pound would be most susceptible to a dysfunctional exit from the EU.

According to Carney, the preparedness of the UK system, which encompasses the country’s trade infrastructure, had seen ‘some progress‘, but ultimately it was for ‘the government to speak directly to that‘ and not the Bank of England.

Gradually over the last three years, the BOE have been carefully positioning themselves so as not to be held culpable for the economic ramifications of a ‘disorderly‘ Brexit. One mechanism for achieving this has been to re-elevate the importance of their 2% mandate for inflation, when in the years post 2008 it had no direct relevance for how the bank conducted monetary policy.

What we learn from Carney is that a no deal eventuality is a more pressing concern for markets and the economy than it is for the financial sector. Is this true? To a point perhaps, but not entirely as the Financial Stability Report alludes to.

An area of concern that has gestated since the referendum result is with uncleared OTC (Over the Counter) derivative contracts. Derivatives are essentially a contract between two or more parties that derive their value from the performance of an underlying asset, such as a commodity, currency or interest rate. Banks use a high degree of leverage to attain these positions in the market. Derivatives can also be used to speculate (bet) on the future value of assets, without the need to own the asset outright.

When it comes to uncleared contracts between the UK and EU, the Financial Policy Committee specifies these as a medium risk should Britain depart with no withdrawal agreement. As for the scale of contracts affected, the report is forthright. Note that the term ‘lifecycle events‘ includes actions such as settlement, modification and termination of derivative contracts.

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