The global economy has been boosted as countries around the world have posted improved economic figures of late, highlighting that Trump’s ‘America first’ attitude has not immediately led to fierce countermeasures. However, despite this positive news, there are signs that inflation may start picking up as well. If this happens there are two likely directions for the global economy:
Firstly, it can be argued that, given the tight labour markets, higher inflation will lead to accelerated wage increases.
It is also possible to argue that, due to high-level international competition and low productivity growth, it will take time for businesses to give in to higher wage demands. This has been evident in Japan and Europe so far and has led to lower consumer purchasing power. If this happens elsewhere economic growth will soon fall back again, as will inflation.
Monetary transition imminent?
It seems that the central banks are leaning towards the first scenario at present. By factoring in the fear of US protectionism harming global trade and therefore growth, they are acting cautiously.
However, there is no longer a great deal of room for policy errors and if growth keeps turning out better than expected, inflation, which has bottomed out, will increase further. This may not happen rapidly at first, but any increase will likely be sufficient for the Bank of Japan and the ECB to start downscaling their enormously loose monetary policies.
As far as Europe is concerned, something else needs to be considered: the important elections taking place this year. There is great concern that populists will emerge powerfully in Europe, which in turn could lead to the collapse of the European Union and the European Monetary Union. The uncertainty that this creates pushes down growth and leads the ECB to keep pursuing its very loose monetary policy for the time being.
That being said, as it looks now, we believe concerns about the outcome of the elections are exaggerated. We actually see the populists securing a substantial share of the votes, but we do not expect them to gain a majority. As a result, we expect the constraining effect on the European economy and ECB policy to disappear in the course of the year. It therefore cannot be ruled out that growth will be slightly better than expected and inflation will be slightly higher than expected over the course of the year. This could lead to a fairly fundamental change for the markets with regard to monetary conditions.
Although the Fed is already gradually tightening monetary policy, the very loose policy of the Bank of Japan and the ECB offsets this. However, if the latter two gradually start moving towards tightening as well, there will be an end to an eight-year period of excessive money creation and abnormally low interest rates. Given that these elements actually represented the key engines behind the financial markets throughout this period, a significant price reaction will be likely. In fact, the markets are already seen to be reacting very tentatively to such a scenario.
Long-term interest rates have largely retained their increase of the past months and are inclined to increase further. However, what is very striking is that inflation has been increasing significantly faster than interest rates of late – perhaps because the markets too, just as the central banks, assume higher inflation will push down growth again. So far, this phenomenon has resulted in real interest rates declining, which actually boosts growth. Better-than-expected growth will soon lead to a worldwide monetary policy being tighter than the markets have become used to. Hence the increase in share prices is beginning to stagnate. Of course, the latter is also due to all the uncertainty caused by Trump.
Europe is also starting to adopt a more cautious approach to the bonds of weaker countries. On the one hand, this is because of the warnings of the IMF with respect to Greece as well as political uncertainty, but it is also due to the possibility of German inflation starting to increase too fast. Berlin is likely to exert increasingly more pressure on the ECB to reduce the purchasing of European bonds. However, once this occurs, there will be mistrust of Italian bonds once again. Hence, interest rates in the weaker countries have come under more upward pressure than those in Germany. These trends should be closely monitored, certainly with a view to the emergence of protectionism, because the Italian economy and government will soon derail in the event of increasing interest rates.
Attempts to talk down the dollar are futile
As part of the ‘America first’ policy stance, the Trump team have made statements lately that are part of an attempt to talk down the dollar exchange rate. For example, China, Germany and Japan have been told they have created an unfair competitive advantage by keeping their currency low, with US business supposedly being the victim of this. The error in the idea from the Trump administration is that trade flows on the currency market only make up a fairly small proportion of turnover. The vast majority concerns international capital movement. So, the movement of a currency rate depends on trade flows, but perhaps even more on capital flows.
One way or the other
Without exploring all manner of theoretical models, this means the following in the current circumstances. The US economy is running at virtually full capacity utilisation and is growing above potential. So, the risk of additional wage increases and inflation is gradually emerging. It should also be remembered that the Fed has created vast amounts of additional money over the past years. It should therefore be wary of inflation increasing excessively. Growth then should be gradually pushed back to potential – approximately 1.75% – in order to prevent inflation from getting out of hand. Hence, the Fed has already indicated it will raise interest rates further. However, the question is to what extent interest rates should be raised to this end.
In Japan and Europe, the loose monetary policy being followed by the central banks means that if the Fed were to raise its rates, so much capital would flow to the US that the dollar would become stronger. This would then cause deterioration in US foreign trade, with the US economy being pushed down in the process. The more this happens, the less the Fed will need to raise its rates to push growth back to approximately 1.75%.
All then that is achieved by talking down the dollar is the Fed having to hike rates more than in the situation where the dollar rate would have increased in tandem. In other words, in terms of ultimate economic growth it does not matter at all whether or not the dollar increases in tandem. However, in the one case the pain will be felt in terms of foreign trade, and in the other it will be fely by anyone who wants to borrow money.
Capital flows reign supreme
Moreover, what the Trump team forgets is that the situation was precisely the other way around a number of years ago. Back then, it was the US that pursued a far looser monetary policy than Europe and Japan. A great deal of capital therefore actually flowed overseas, resulting in an enormous decline in the rate of the dollar. EUR/USD is currently at 1.07, while purchasing power parity is somewhere around 1.20. However, at the time the rate soared all the way to 1.40 – 1.60, as a result of which there was a far greater overshoot than now.
Incidentally, it is important to note: history shows that interventions – both verbally and on the currency market – can never push currency rates up or down for long. Capital flows will always win in the end, unless the fundamentals change (eg higher or lower interest rates). So, in the current case the dollar exchange rate may be kept low for a while or even be pushed down, but if the result is even higher US interest rates, the dollar exchange rate will ultimately still increase.
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