Buckle up: poorly designed US stimulus is recklessly large
America’s extraordinary fiscal gamble is adding to an economy already running hot
Volatility is back. A long spell of calm, in which America’s stockmarket rose steadily without a big sell-off, ended abruptly this week. The catalyst was a report released on February 2 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. And then lost it again. 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, the US is adding a hefty fiscal boost to juice up an expansion that is already mature. Public borrowing is set to double to $US1 trillion, or 5 per cent of GDP, in the next fiscal year. What is more, the team steering this experiment, 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.
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 the US, 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, US stock prices have fallen back only to around where they were at the beginning of the year.
Yet this episode does signal just what may lie ahead. After years when investors could rely on central banks for support, the safety net of extraordinarily loose monetary policy is slowly being dismantled. The US 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 per cent in September to 2.8 per cent. Sharemarkets 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 the US’s impending fiscal bet.
Economists reckon Donald Trump’s tax reform, which lowers bills for companies and wealthy Americans — and to a lesser extent for ordinary workers — will jolt consumption and investment to boost growth by about 0.3 per cent 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 childcare and other goodies; hawks in both parties have won more money for the defence budget. Trump 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 healthcare costs, and the US is set to run deficits above 5 per cent of GDP for the foreseeable future. Excluding the deep recessions of the early 1980s and 2008, the US 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, US 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.
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 80s. But in the short term, most hangs on Powell, who must steer between two opposite dangers.
One is that he is too dovish, 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, 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 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.
Second, the risk of a sudden burst of inflation is limited. Wage growth has picked up only gradually in the US. 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, boosting productivity growth.
To be clear, the fiscal stimulus that America is undertaking is poorly designed and recklessly large. It will add to financialmarket volatility. But now this experiment is under way, it is even more important the Fed does not lose its head.
The dovish new Federal Reserve chairman, Jerome Powell