Christine Lagarde had good news to tell when she turned up in Davos three weeks ago to announce the International Monetary Fund’s latest economic forecasts. The global economy was doing better than expected pretty much everywhere, the IMF’s managing director said.
There was, though, another message, a warning not to get too carried away about a recovery that had left out large numbers of people and was not based on particularly solid foundations. “There is also significant uncertainty in the year ahead,” Lagarde said. “The long period of low interest rates has led to a buildup of potentially serious financial sector vulnerabilities.”Quick guide The stock market drop Show Hide
For several weeks, economists and analysts have warned that inflation levels in major economies could increase this year beyond the 2% to 3% that central banks believe is good for developed countries. Official US figures turned those concerns into a sell-off last Friday, after they showed average wage rises in the US had reached 2.9%. The data increased fears that shop prices would soon rise further, increasing the pressure for high interest rates to calm the economy down. Investors then bolted at the prospect of an era of cheap money – which encourages consumers and companies to spend – coming to an end. Over the past month, several members of the US central bank, the Federal Reserve, have argued that three 0.25% interest rate rises scheduled for this year could become four or five.
There is every prospect that the US economic data will continue to strengthen, increasing the potential for higher interest rates. President Donald Trump’s tax reform bill, which gained approval in Congress before Christmas, will inject more than $1tn (£710bn) into the US economy, much of it in the form of corporation tax cuts. Many firms have pledged to give a slice of the cash to their workers. Decades of flat wages should mean that increases expected in 2018 and possibly 2019 are too small to trigger a reaction from the central bank, but investors are betting rates will rise. As a consequence, stock market jitters could continue.
Many developing world economies have borrowed heavily in dollars and will be stung by the higher cost of servicing their debts. On the other hand, a booming US economy will suck in imports from those nations, boosting the incomes of the developing world. However, the eurozone looks unlikely to increase interest rates until its recovery is more firmly anchored. That means the euro will continue to rise in value against the dollar, making it harder for European countries to export to the US.
The IMF does not always get it right but on this occasion Lagarde nailed it. Over the past week, shares on Wall Street have fallen sharply, with the Dow Jones recording 1,000-point-plus declines on two separate days.
Speaking in Dubai on Sunday, in her first public comments since the market turmoil, Lagarde said she remained “reasonably optimistic” but that “we cannot sit back and wait for growth to continue as normal”.
Somewhat perversely, the markets came down for the same reason as they rose steadily throughout 2017: because of the brighter economic news Lagarde reported. The trigger for the sell-off was a US labour market report, which showed more jobs being created, wages going up and unemployment at 4.1%.
Most Americans would struggle to work out why this would cause share prices to plunge. After all, unemployment has been coming down steadily for years, during which time US workers have struggled to make ends meet. Annual earnings growth is still running below 3%.
But from the perspective of Wall Street, these are now seen as unwelcome developments. In 2017, the financial markets bought shares because they thought the US was in for a prolonged period of strong growth, weak inflation and low interest rates.
The moment the jobs report came out it was as though a switch had been flipped. Markets now viewed stronger US growth with trepidation because they thought it would result in higher inflation and tougher action from the US central bank, the Federal Reserve. Donald Trump’s package of tax cuts, finally pushed through Congress at the end of last year, ceased to be the growth-boosting, productivity enhancing benefit to the economy it had been in 2017 and suddenly became a means of overheating the economy and driving up the US budget deficit. Because Washington would need to borrow more to bridge the gap between its spending and its tax revenue, the assumption was that interest rates would need to rise.
As it happens, some of Wall Street’s assumptions are questionable. Take the idea that America is running at full employment, for example, where the 4.1% jobless rate masks the fact that labour market participation has yet to get back to where it was at the start of the Great Recession a decade ago. America’s employment rate is currently just over 60% – 3 percentage points lower than it was in 2008.Q&A What is inflation and why does it matter? Show Hide
Inflation is when prices rise. Deflation is the opposite – price decreases over time – but inflation is far more common.
If inflation is 10%, then a £50 pair of shoes will cost £55 in a year"s time and £60.50 a year after that.
Inflation eats away at the value of wages and savings – if you earn 10% on your savings but inflation is 10%, the real rate of interest on your pot is actually 0%.
A relatively new phenomenon, inflation has become a real worry for governments since the 1960s.
As a rule of thumb, times of high inflation are good for borrowers and bad for investors.
Mortgages are a good example of how borrowing can be advantageous – annual inflation of 10% over seven years halves the real value of a mortgage.
On the other hand, pensioners, who depend on a fixed income, watch the value of their assets erode.
The government"s preferred measure of inflation, and the one the Bank of England takes into account when setting interest rates, is the consumer price index (CPI).
The retail prices index (RPI) is often used in wage negotiations.
Nor was the rise in wages quite all that it seemed, since most of the beneficiaries were those in senior positions. Annual earnings growth for those in “production non-supervisory” positions – the bottom 83% of the jobs market – was 2.4%.
But Wall Street’s assumption that the Federal Reserve is keen to raise interest rates is correct. The City is getting a similar message from the Bank of England, that UK borrowing costs might need to go up faster than hitherto expected.
There is no suggestion that interest rates will need to rise to their pre-crisis levels. Indeed, both the Fed and the Bank of England have been at pains to point out that the tightening of policy will be gradual and modest. Threadneedle Street probably envisages raising rates to around 2.5% in quarter-point steps over the coming years, which would leave them well below the 5% average since the Bank was founded in 1694.
Yet even this looks quite a stretch. For almost a decade now, the major developed economies have relied on heavy doses of stimulus from their central banks to generate growth. Interest rates have had to be kept low and money printed on an enormous scale through the process known as quantitative easing because finance ministries have adopted austerity policies – higher taxes and cuts in public spending – in an attempt to reduce budget deficits.
This mix of ultra-loose monetary policy and hardline fiscal policy was a mistake. It explains why the NHS – experiencing its toughest budgetary constraints since it was founded in 1948 – is struggling to cope with demand. It also explains why the only real signs of serious inflation in recent years have been for fine wine, expensive houses and old masters.
There were gasps of surprise when Leonardo da Vinci’s Salvator Mundi was knocked down for $400m at auction last year, more than three times the price experts had predicted, but the explanation was obvious. Rockbottom interest rates and QE have driven up the price of assets sought by the already well off. It has been the classic case of too much money chasing too few goods.
Elsewhere, it has been harder to find signs of overheating. In the UK, for example, food prices have risen by just 2% in the past three years even accounting for the increases that have resulted from the pound’s post-EU referendum depreciation.
Trump’s tax cuts have been widely condemned and, to the extent that they are pro-rich, the criticism is justified. But in two respects they are welcome: they make growth a higher priority than deficit reduction and they provide a better balance between monetary and fiscal policy.
Central banks have for too long been the only game in town, which makes raising interest rates problematic. They want scope to ease policy in the event of another recession, but if they are too hasty they themselves will be responsible for the downturn.
- Economics viewpoint
- Stock markets
- US economic growth and recession
- Economic growth (GDP)
- Quantitative easing
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