Fog of Brexit clouds outlook for central banks seeking clarity

Thu Jul 7, 2016 1:05am EDT
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By Howard Schneider and Ann Saphir

WASHINGTON (Reuters) - For much of this year, the dollar, oil prices, and economic conditions largely behaved as the U.S. Federal Reserve had expected, allowing policymakers to plot further interest rate increases.

Not anymore. Since Britain's June 23 vote to leave the European Union, every piece of economic, such as Friday's jobs report, data comes with a question mark - how much does it reflect domestic economic developments and how much the short and long-term implications of an economic reordering that may take years to play out.

For Fed policymakers it means balancing the mainly positive flow of U.S. indicators against the risk that major trading partners fall into recession, the dollar surges again, or the terms of Britain's divorce stress the global financial system.

With past overseas events of similar importance, such as the euro zone debt crisis, it has taken the Fed months to get clarity. Brexit may prove just as difficult to decipher, already helping lift the dollar and drive U.S. Treasury yields to historic lows - both trends making it harder for the Fed to move.

"You don't know how long that is going to last and indeed we don't know the magnitude," Federal Reserve Governor Daniel Tarullo said on Wednesday. "I doubt there will be a moment where people say, okay, Brexit is done."

Britain's decision comes at time when the Fed has grown more sensitive to international events, postponing what seemed to be imminent rate increases twice since last summer because of events far from U.S. borders. In minutes of the June meeting, released on Wednesday, policymakers explicitly tied consideration of further rate increases to "additional data on the consequences of the UK vote".

No one expects the United States to slip into a recession because of Brexit. However, recent research by the Fed, the Bank for International Settlements, the International Monetary Fund and some private economists has raised the possibility that the Fed may be fundamentally constrained by outside events, like the UK vote, that have made recovery slow and the Fed's inflation goal elusive.

The dollar appears to have become more sensitive to global economic conditions, and its rapid rise since 2014 has curbed U.S. exports and upended the Fed's inflation outlook. Long-term U.S. bond yields, which remained near record lows on Wednesday, have grown more sensitive to global capital flows and less to Fed policy. Even the Fed's key estimate of a neutral rate of interest may be anchored by such rates in Europe and other, slower-growing, developed economies.   Continued...

A Union flag flies next to the flag of the European Union in Westminster, London, Britain June 24, 2016.    REUTERS/Toby Melville/File Photo