The United Kingdom shocked the world last night when it voted to leave the European Union, contrary to what polls leading up to the vote were predicting.
The effect on the British economy will be widespread, but will the turmoil wash up on American shores?
Here are some guidelines for how the American economy will weather this storm, according to Torsten Slok, Chief International Economist with Deustche Bank Securities, who points to the Federal Reserve’s model of the U.S. economy combined with predictions for how financial markets will continue to digest Brexit:
- A 10% appreciation in the dollar will cut U.S. GDP by 0.4% after one year;
- An increase in BBB yields of 1%—as investors move away from riskier corporate borrowers—will lower GDP by 0.2%;
- A sustained 20% decline in the S&P 500—which may be the result of increased volatility following the vote—lowers GDP by 0.2% and raises the unemployment rate by 0.1%; and
- A 100 basis-point decline in the 10-year rate U.S. Treasury rate—as investors flee to the safe government bonds—will increase GDP by 0.4%.
We won’t know for sure the full impact on the U.S. economy until we see how financial markets digest the information today and in coming weeks. In recent trading Friday, the S&P 500 was down 2.5% and the yield on the 10-year Treasury dropped as much as 34 basis points to 1.40% before bouncing back to 1.55%.
But the net effect of Slok’s scenario would be a 0.4% decline in U.S. GDP, which is significant but not enough at this point to pull the United States into recession. “That said if growth abroad weakens and financial conditions tighten further, then the negative impact on the U.S. economy would be growing over time,” Slok writes in an email to clients.
Jim O’Sullivan, Chief U.S. economist with High Frequency Economics, argued in an email that the key data to watch in terms of the unfolding effects of Brexit on the United States is the stock market. “The keys to whether the U.S. economy is affected significantly will be whether equities tumble enough to have a major impact on business and consumer confidence and whether banks are affected such that they pull back on lending.”
The other major variable is how the Fed will react. “The tightening in financial conditions…only adds to the case for the Fed to hold off on tightening pending more information,” O’Sullivan writes. “But, again, much will depend on the extent to which there is follow-through—or reversal—of the initial market moves.”
In a statement Friday morning, the Fed declared:
The Federal Reserve is carefully monitoring developments in global financial markets, in cooperation with other central banks, following the results of the U.K. referendum on membership in the European Union. The Federal Reserve is prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy