The catalyst was a report released on February 2nd showing that wage growth in America had accelerated. The S&P 500 fell by a bit that day, and by a lot on the next trading day. The Vix, an index that reflects how changeable investors expect equity markets to be, spiked from a sleepy 14 at the start of the month to an alarmed 37. In other parts of the world nerves frayed.
Markets later regained some of their composure (see article). But more adrenalin-fuelled sessions lie ahead. That is because a transition is under way in which buoyant global growth causes inflation to replace stagnation as investors’ biggest fear. And that long-awaited shift is being complicated by an extraordinary gamble in the world’s biggest economy. Thanks to the recently enacted tax cuts, America is adding a hefty fiscal boost to juice up an expansion that is already mature. Public borrowing is set to double to $1 trillion, or 5% of GDP, in the next fiscal year. What is more, the team that is steering this experiment, both in the White House and the Federal Reserve, is the most inexperienced in recent memory. Whether the outcome is boom or bust, it is going to be a wild ride.Fire your engines
The recent equity-market gyrations by themselves give little cause for concern. The world economy remains in fine fettle, buoyed by a synchronised acceleration in America, Europe and Asia. The violence of the repricing was because of newfangled vehicles that had been caught out betting on low volatility. However, even as they scrambled to react to its re-emergence, the collateral damage to other markets, such as corporate bonds and foreign exchange, was limited. Despite the plunge, American stock prices have fallen back only to where they were at the beginning of the year.
Yet this episode does signal just what may lie ahead. After years in which investors could rely on central banks for support, the safety net of extraordinarily loose monetary policy is slowly being dismantled. America’s Federal Reserve has raised interest rates five times already since late 2015 and is set to do so again next month. Ten-year Treasury-bond yields have risen from below 2.1% in September to 2.8%. Stockmarkets are in a tug-of-war between stronger profits, which warrant higher share prices, and higher bond yields, which depress the present value of those earnings and make eye-watering valuations harder to justify.
This tension is an inevitable part of the return of monetary policy to more normal conditions. What is not inevitable is the scale of America’s impending fiscal bet. Economists reckon that Mr Trump’s tax reform, which lowers bills for firms and wealthy Americans—and to a lesser extent for ordinary workers—will jolt consumption and investment to boost growth by around 0.3% this year. And Congress is about to boost government spending, if a budget deal announced this week holds up. Democrats are to get more funds for child care and other goodies; hawks in both parties have won more money for the defence budget. Mr Trump, meanwhile, still wants his border wall and an infrastructure plan. The mood of fiscal insouciance in Washington, DC, is troubling. Add the extra spending to rising pension and health-care costs, and America is set to run deficits above 5% of GDP for the foreseeable future. Excluding the deep recessions of the early 1980s and 2008, the United States is being more profligate than at any time since 1945.
A cocktail of expensive stockmarkets, a maturing business cycle and fiscal largesse would test the mettle of the most experienced policymakers. Instead, American fiscal policy is being run by people who have bought into the mantra that deficits don’t matter. And the central bank has a brand new boss, Jerome Powell, who, unlike his recent predecessors, has no formal expertise in monetary policy.
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What will determine how this gamble turns out? In the medium term, America will have to get to grips with its fiscal deficit. Otherwise interest rates will eventually soar, much as they did in the 1980s. But in the short term most hangs on Mr Powell, who must steer between two opposite dangers. One is that he is too doveish, backing away from the gradual (and fairly modest) tightening in the Fed’s current plans as a salve to jittery financial markets. In effect, he would be creating a “Powell put” which would in time lead to financial bubbles. The other danger is that the Fed tightens too much too fast because it fears the economy is overheating.
On balance, hasty tightening is the greater risk. New to his role, Mr Powell may be tempted to establish his inflation-fighting chops—and his independence from the White House—by pushing for higher rates faster. That would be a mistake, for three reasons.
First, it is far from clear that the economy is at full employment. Policymakers tend to consider those who have dropped out of the jobs market as lost to the economy for good. Yet many have been returning to work, and plenty more may yet follow (see article). Second, the risk of a sudden burst of inflation is limited. Wage growth has picked up only gradually in America. There is little evidence of it in Germany and Japan, which also have low unemployment. The wage-bargaining arrangements behind the explosive wage-price spiral of the early 1970s are long gone. Third, there are sizeable benefits from letting the labour market tighten further. Wages are growing fastest at the bottom of the earnings scale. That not only helps the blue-collar workers who have been hit disproportionately hard by technological change and globalisation. It also prompts firms to invest more in capital equipment, giving a boost to productivity growth.
To be clear, this newspaper would not advise a fiscal stimulus of the scale that America is undertaking. It is poorly designed and recklessly large. It will add to financial-market volatility. But now that this experiment is under way, it is even more important that the Fed does not lose its head.
- The Economist