What the Brexit vote means for the US economy

For weeks, there have been a lot of headlines crossing about this so-called Brexit vote.

Brexit is the abbreviation for “British exit from the European Union.” Unhappy with having EU policies forced on them, anti-EU Brits organized and called for a vote. And in a surprise development on Thursday, Britain voted to leave. Specifically, 52% of voters voted to leave as 48% voted to remain.

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For our purposes, we’re gonna skip what the Brexit vote means for everyone else and focus on what it means for the US.

What the Brexit vote means for the US: Tighter financial conditions

While the US economy and the companies in the US stock market have limited exposure to the UK, they’re all nevertheless affected by what’s unfolding.

The first thing most economists are flagging right now is tighter financial conditions. Simply put, tighter financial conditions means that it is harder and more expensive for businesses and consumers to get money. That in turn leads to less borrowing, less investing, and ultimately less economic activity.

And these tighter financial conditions are appearing in the US.

“The sharp fall in stock prices in most economies and the widening of credit spreads represent a tightening of financial conditions,” Wells Fargo’s Jay Bryson said. “If financial conditions remain tight in coming weeks, economic activity in many economies could decelerate from already lackluster rates of growth.”

On Friday, the S&P 500 (^GSPC) plunged 75 points or 3.6%. The Dow (^DJI) fell 610 points or 3.4%.

Expect the Fed to keep monetary policy loose for longer
This comes at a time when the Federal Reserve has been planning to actively tighten financial conditions through tighter monetary policy. Why would they want to do this? Because the economy has made great strides in the past seven years since the end of the financial crisis, which means the economy is actually at risk of overheating.

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But with these new developments out of the UK — combined with other recent signs of slowdown — economists agree that tighter monetary policy — which the Fed has been rolling out with interest rate hikes — is likely to be put off for now.

“The Fed will likely delay the hiking cycle,” Bank of America Merrill Lynch’s Ethan Harris said. “We expect the next hike to be in December versus our prior forecast of September. Given the high degree of uncertainty, we will be nimble to adjust forecasts as needed depending on financial conditions.”

Harris isn’t the only economist who believes that rate hikes will be put off until the end of the year. His peers at Nomura, JPMorgan, Morgan Stanley, and UBS all see the Fed waiting until December until the next rate hike comes. ING’s Rob Carnell thinks the next rate hike won’t come until 2017.

The good news
Historically, these types of shocks rarely have long-lasting affects. Event-driven sell-offs in the financial markets are usually followed by huge rallies.
It’s a similar story for economic growth, especially for regional shocks. Renaissance Macro’s Neil Dutta considered other major regional shocks from recent history.
“Examples include the European Exchange Rate Mechanism crisis in the early 1990s, the Tequila crisis of the mid-1990s, and the Asian financial crisis in the late 1990s,” Dutta observed. “We saw regional recessions that did not bleed to the rest of the world.”
Dutta believes that the US economy could experience “a possible GDP hit of anywhere from 0.2 to 0.6ppt to US GDP over the next year” following this Brexit vote. But he also sees growth to improve thanks to, among other things, loose monetary policy.