In normal times, if the ECB lowers its key rates, the banks’ financing costs decrease, allowing them to pass these lower costs on to the lending rates they offer to customers, companies or households. BIS central bankers’ speeches  3  However, we noticed that this channel was no longer functioning correctly in the euro area. In fact, we noticed that a drop in key rates was feeding through to lower lending rates in certain parts of the euro area, but not everywhere. This means a fundamental aspect of our monetary policy and of its efficacy – i.e. its singleness – was impaired. As a result, major differences in bank lending rates appeared across euro area countries, which could not be explained by disparities by the fundamentals of the countries concerned. For example, two hotels with the same activities and financial characteristics and located on each side of the Austro-Italian border are obliged to borrow at substantially different rates. This is not because of a real difference in the credit risk. In reality, this rate differential stems from the fact that certain segments of the financial markets had developed fears regarding a possible break-up of the euro area. They were adding to the rates they were offering certain countries a risk premium to cover a “re-denomination” of bonds into the local currency.
For the time being, the UK has conducted a referendum and triggered Article 50 but doesn’t leave the European Union until March next year: there are no tariff or trade barriers. Yet the pound fell immediately after the referendum result in anticipation of more difficult external trading conditions in the future; this has substantially hurt the purchasing power of UK households. Business investment slowed down – as apparently it has in Canada due to NAFTA uncertainty. The Bank of England estimates that UK real GDP is already 1¾-2% lower than it otherwise would be as a result of Brexit. Fiscal policy Uncertainty about fiscal policy in many advanced economies is a second source of policyinduced uncertainty. Public debt has risen significantly since the Great Recession. Average gross government debt in the Euro Area rose from around 65% of GDP in 2007 to peak at over 90% in 2014 and is currently still over 85%, despite the fact that primary balances have improved on average across the Euro Area. The macroeconomic costs of fiscal uncertainty can be felt even without an actual sovereign debt crisis. Risk premia increase and raise the cost of borrowing but without any riskadjusted increase in return for savers. The risks of fiscal uncertainty are highly non-linear and one could almost say binary due to the reaction function of financial markets, as we have seen since 2010 in the Euro-zone. Below a certain threshold, fiscal uncertainty has very limited effects on sovereign borrowing spreads or economic activity.