Buckle up: poorly de­signed US stim­u­lus is reck­lessly large

Amer­ica’s ex­tra­or­di­nary fis­cal gam­ble is adding to an econ­omy al­ready run­ning hot

The Weekend Australian - - INQUIRER - THE ECON­O­MIST

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.

AP

The dovish new Fed­eral Re­serve chair­man, Jerome Pow­ell

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