Tue, Feb 07, 2017 - Page 8 News List

Three surprises for the new year

By Anatole Kaletsky

Economic pundits traditionally offer their (traditionally inaccurate) New Year predictions at the beginning of January, but global conditions this year are anything but traditional, so it seemed appropriate to wait until US President Donald Trump settled into the White House to weigh in on some of the main surprises that might shake up the world economy and financial markets on his watch. Judging by market movements and conditions, the world could be caught off guard by three potentially transformative developments.

For starters, Trump’s economic policies are likely to produce much higher US interest rates and inflation than financial markets expect. Trump’s election has almost certainly ended the 35-year trend of disinflation and declining rates that began in 1981, and that has been the dominant influence on economic conditions and asset prices worldwide, but investors and policymakers do not believe it yet. The US Federal Reserve Board’s published forecasts suggest only three quarter-point rate hikes this year and futures markets have priced in just two such moves.

However, as Trump launches his policies, the Fed is likely to tighten its monetary policy more than it had planned before the inauguration, not less, as the markets still expect. More important, as Trump’s policies boost both real economic activity and inflation, long-term interest rates, which influence the world economy more than the overnight rates set by central banks, are likely to rise steeply.

The rationale for this scenario is straightforward. Trump’s tax and spending plans will sharply reverse the budget consolidation enforced by Congress on former US President Barack Obama’s administration and household borrowing will expand dramatically if Trump fulfills his promise to reverse the bank regulations imposed after the 2008 financial crisis. As all this extra stimulus fuels an economy already nearing full employment, inflation seems bound to accelerate, with protectionist trade tariffs and a possible “border tax” raising prices even more for imported goods.

The only uncertainty is how monetary policy will respond to this “Trumpflation,” but whether the Fed tries to counteract it by raising interest rates more aggressively than its current forecasts imply, or decides to move cautiously, keeping short-term interest rates well behind the rising curve of price growth, bond investors are likely to suffer.

In Europe and Japan, monetary conditions are likely to remain loose, as central banks continue to support economic growth with zero interest rates and quantitative easing. This policy divergence suggests a second potential shock for which financial markets seem unprepared.

The US dollar could rise much higher, especially against emerging-market currencies, despite Trump’s stated desire to boost US exports.

A confluence of dollar strength and excessive foreign borrowing caused the debt crises in Latin America and Asia in the 1980s and 1990s. This time, Trump’s protectionism could make matters even worse, especially for countries such as Mexico and Turkey, which have based their development strategies on rapidly expanding exports and have financed domestic business activity with dollar debts.

So much for the bad news. Fortunately, a third major development that is not priced into financial markets could be more favorable for global economic conditions: The EU — an even more important market than the US for almost every trading country apart from Mexico and Canada — could do much better than expected this year.

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