Brexit: the Biggest Global Monetary Shock Since 2008

The figure also shows that this sudden increase in the dollar is closely tied to the policy divergence between the Fed and the ECB (blue line). That is, as the Fed began talking up interest rate hikes in mid-2014 the ECB was talking up the easing of monetary policy. The rise in the blue line shows this divergence¹

Brexit is now adding fuel to the dollar fire. The dollar has appreciated almost 4 percent since the Brexit fate became clear last evening, as seen in the figure below.

In the open economy, the scarcity of safe assets spreads from one country to the other via the capital account. Net safe asset producers export these assets to net safe asset absorbers until interest rates are equalized across countries. As the global scarcity of safe assets intensifies, interest rates drop and capital flows increase to restore equilibrium in global and local safe asset markets. Once the ZLB is reached, output becomes the adjustment variable again. 

This frantic race to the bottom of safe yields will eventually run up against the effective lower bound (ELB). When that happens something else w.ill have to adjust. And that something is output, as noted by Caballero, Fahri, and Gourinchas (2016)

So there you have it. The world has been hit with a massive global monetary shock. And via dollar bloc countries, the parallel dollar system, and the shortage of safe asset problem this monetary shock may be what pushes an already slowing global economy into a global recession.

Will central bankers and finance ministries be ready for it? I hope so.

¹The blue line shows the spread between the 1-year US treasury rate and the 1-year Euro rate. Based on the expectation hypothesis, the 1-year interest rate approximately equals the expected average of short-term interest rates over the same horizon. Consequently, if 1-year rates are going up it implies short-term rates are expected to rise on average over the next year. The spread between the treasury and euro rates, then, reveals the expected divergence between the expected path of policy interest rates over the next year.