MNI INTERVIEW: Chadha: Mkts May Be Right Pricing BOE Brexit QE

--Risk Premia Fall On Adverse Brexit News, Assume BOE Action: NIESR's Chadha

By David Robinson

     LONDON (MNI) - Financial markets may well be correct to price in hefty Bank

of England stimulus in the case of a disorderly Brexit, despite protestations

from the central bank that rates may rise, Jagjit Chadha, Director of the

National Institute of Economic and Social Research told MNI in an interview.

     Chadha and colleagues at NIESR looked at risk premia moves in response to

adverse Brexit news and found that, strikingly, rather than rising because the

UK was seen as riskier, they fell. He told MNI that markets appeared to be

assuming that in the most adverse scenarios the BOE Monetary Policy Committee

would restart quantitative easing.

     NIESR created an index of how likely markets thought further QE was going

to be and looked at the correlation with risk premia changes.

     "We saw that the more the markets thought that they was going to be QE the

lower the risk premium went. So they were building in a reaction from the

central bank to bad news that would offset the potential increase in the risk

premium," Chadha said.

     --BANK AMBIGUOUS

     BOE Governor Mark Carney and colleagues have warned as recently as this

week that Bank Rate could be forced higher if there is a substantial supply

shock from a disorderly Brexit, sterling falls and consumption is relatively

resilient. But market pricing does not reflect this.

     Chadha reckoned that the response of supply and demand to a disorderly

Brexit shock might tilt the scales in the markets' direction -- to more

stimulus.

     "If you felt that the first response from a disorderly exit was a radical

shift in the demand curve downward, that would (result in) a negative output gap

and then you would want interest rates to fall rather than rise," he said.

     Both supply and demand are likely to be hit by a disorderly Brexit. A key

factor is which moves first.

     "My feeling, and I think the Bank also feels this as well ... (is) that

supply probably moves more slowly in response to shocks. Even though it might

ultimately move by as much as demand it is a more slowly evolving beast than

demand," Chadha said.

     One of the most controversial parts of the BOE's recent Brexit scenario

analysis was its assumption that Bank Rate could rise from its current 0.75% to

5.5% on a disorderly Brexit.

     Chadha said that the BOE had created "a near worse case scenario" which

mimicked what would happen if the interest rates faced by borrowers spiked

because risk premia surged wider as markets ditched UK assets.

     "There is always a world in which ... markets are going to take fright,

there is a sudden stop, (investors) don't want to hold those domestic currency

assets and risk premia start to rise," Chadha said.

     With political uncertainty so high in the UK, however, it is possible to

imagine scenarios in which the BOE struggles to get authorisation from a future

government for QE and the expected policy response does not materialize.

     --FORECASTING DIFFICULTY

     While forecasting variants of smooth Brexit is possible using linear

models, a disorderly Brexit was a different beast altogether.

     "Once you get into the disorderly world, ports aren't working, medicines

aren't turning up, markets may or may not be functioning in a way, bank finance

may be difficult to get hold of ... then it becomes more like story telling," he

said.

--MNI London Bureau; tel: +44 203-586-2223; email: david.robinson@marketnews.com

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