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Bank of England busy preparing for Brexit vote

Chris Giles
Bank of England prepares for Brexit

The Bank of England is consumed with preparing contingency plans for Britain to leave the EU, with staff across its financial stability, monetary policy and regulatory wings ready to calm any turmoil.

In the days leading up to the June 23 poll, the Bank will hold additional auctions of sterling to ensure the banking system has sufficient funds to operate in a potentially chaotic moment.

Three exceptional auctions of cash have already been planned for June 14, 21 and 28. But stuffing the banks full of cash will not prevent foreigners and UK households and companies dumping sterling in the event of a Brexit vote.

Michael Saunders, the new member of the bank's Monetary Policy Committee, expects the pound to come under severe pressure. While still at Citi, he wrote that Brexit risks were "nowhere near priced yet", adding that Britain should expect a 15 to 20 per cent depreciation of sterling against Britain's main trading partners.

If such a decision to flee leads British banks to become short of foreign currency, the BoE will rapidly offer foreign currency loans to the financial system, using swap lines with other central banks still in existence from the financial crisis.

Philip Shaw of Investec said that using such swap lines would be needed only in "fairly extreme circumstances" and the BoE would also need to "make reassuring noises about the soundness of the financial system" to help shore up confidence.

Officials are already pointing to the 2014 stress test of banks, which assumed a reassessment of the health of the UK economy led to a "depreciation of sterling", to suggest that the banking system would cope.

"Unless any UK financial institutions have bet their shirt on an early recovery of sterling it is hard to see what Brexit would do in immediate terms," said Stephen Wright, a professor at Birkbeck College, London University.

The week after the referendum, the Financial Policy Committee will have an opportunity to loosen the requirements for banks to hold capital if there is a financial panic, putting in place the new regime of measures to counter the credit cycle.

But even if the BoE could cope with immediate market gyrations from Brexit, it would soon face what Mr Saunders called "a major policy dilemma" over interest rates.

George Osborne has suggested interest rates will rise if the pound slumps, bringing a bout of inflation and making households worse off. The chancellor told journalists last month [April] that the financial instability would imply "mortgage rates are likely to go up".

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But BoE officials see the world differently. A letter Mark Carney sent to MPs in late March sets out that the result the governor fears is stagflation — higher inflation from the drop in sterling pushing up import prices, without the usual boost to demand because of a confidence shock to the UK economy.

The result of Brexit would then be the central bankers' nightmare of what Mr Carney described as "a lower path for growth and a higher path for inflation".

Most observers believe the BoE would be more inclined to respond to the shock to spending with lower rates.

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"Other things being equal it would be the MPC's job to loosen policy, and therefore to be happy for sterling to depreciate, just as they were in 2008," said Prof Wright.

But Jagjit Chadha, director of the National Institute of Economic and Social Research, said that any further delay in raising rates would bring complications because it would require "some innovations in the communication and explanation of the policy stance, particularly if a sudden fall in sterling leads to a temporary inflation and missed inflation target".

The MPC is highly unlikely to respond quickly to Brexit, analysts said, and at the earliest would move monetary policy in August once the politics and policy became clearer.

Mr Osborne might not be wrong. Even if official interest rates stay the same or fall, if the UK is seen as a worse bet for lending, banks might be forced to raise the cost of loans just as they were in 2007-08.

Dealing with the extreme uncertainty of Brexit is not what most senior BoE officials want and some are already complaining about the risk to their summer holidays, but they cannot say this publicly as the central bank has promised to remain neutral in the referendum campaign.