The stock market turmoil was above all good economic news | Larry Elliot


VShrstine Lagarde had good news to report when she traveled to Davos three weeks ago to announce the latest economic forecasts from the International Monetary Fund. The global economy was doing better than expected across the board, said the managing director of the IMF.

There was another message, however, a warning not to get too carried away with a recovery that had left out a lot of people and didn’t have a particularly strong foundation. “There is also significant uncertainty in the coming year,” Lagarde said. “The long period of low interest rates has led to a build-up of potentially serious financial sector vulnerabilities.”

Quick Guide

The fall of the stock market

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Why are stock markets falling?

For several weeks, economists and analysts have warned that inflation levels in major economies could rise this year beyond the 2-3% that central banks believe is good for developed countries. Official US figures turned those worries into a sell-off last Friday, after showing that the average wage increase in the United States had reached 2.9%. The data heightened fears that store prices could soon rise further, increasing pressure for high interest rates to calm the economy. Investors then panicked at the prospect of an era of cheap money – which encourages consumers and businesses 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 hikes scheduled for this year could become four or five.

Is there worse to come?

There is every reason to believe that US economic data will continue to strengthen, increasing the potential for higher interest rates. President Donald Trump’s tax reform bill, which was approved by Congress before Christmas, will inject more than $1bn (£710bn) into the US economy, much of it in the form of corporate tax cuts. Many companies have pledged to give a share of the money to their workers. Decades of fixed wages should mean increases expected in 2018 and possibly 2019 are too small to trigger a central bank response, but investors are betting rates will rise. As a result, market jitters could continue.

Is it a threat to the global economy?

Many economies in the developing world 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 these countries, thereby increasing the incomes of the developing world. However, the Eurozone seems unlikely to raise interest rates until its recovery is more firmly entrenched. This means that the euro will continue to rise in value against the dollar, making it harder for European countries to export to the United States.

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The IMF is not always right, but on this occasion, Lagarde succeeded. Over the past week, stocks on Wall Street have fallen sharply, with the Dow Jones posting declines of more than 1,000 points 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, markets fell for the same reason they rose steadily throughout 2017: because of the more positive economic news reported by Lagarde. The trigger for the sell-off was a report on the US labor market, which showed more jobs being created, wages rising and unemployment hitting 4.1%.

Most Americans would struggle to understand why this would drive stock prices down. After all, unemployment has been falling steadily for years, during which time American workers have struggled to make ends meet. Annual earnings growth is still below 3%.

But from Wall Street’s perspective, these are now seen as unwelcome developments. In 2017, financial markets bought stocks because they believed the United States was going to have a prolonged period of strong growth, low inflation and low interest rates.

By the time the jobs report came out, it was like a switch had been flipped. Markets were now looking at stronger US growth with trepidation because they believed it would translate into higher inflation and tougher action by the US central bank, the Federal Reserve. Donald Trump’s tax cut package, finally passed by Congress late last year, has ceased to be the growth and productivity-boosting benefit to the economy that it once had. summer in 2017 and suddenly became a way to overheat the economy and drive up the US Budget Deficit. Since Washington would need to borrow more to close the gap between its spending and tax revenue, the assumption was that interest rates would have to rise.

It turns out that some of Wall Street’s assumptions are questionable. Take the idea that America is operating at full employment, for example, where the 4.1% unemployment rate masks the fact that labor force participation has not yet returned to the level it was at the start of the Great Recession ten years ago. The US employment rate is currently just over 60%, 3 percentage points lower than it was in 2008.

Questions and answers

What is inflation and why is it important?

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Inflation is when prices go up. Deflation is the opposite – prices go down over time – but inflation is much more common.

If inflation is 10%, a £50 pair of shoes will cost £55 in a year and £60.50 a year thereafter.

Inflation eats away at the value of wages and savings – if you earn 10% on your savings but inflation is 10%, the real interest rate on your kitty is actually 0%.

A relatively new phenomenon, inflation has become a real concern for governments since the 1960s.

Generally, periods of high inflation are good for borrowers and bad for investors.

Mortgages are a good example of how good borrowing can be – 10% annual inflation over seven years halves the real value of a mortgage.

On the other hand, retirees, who depend on a fixed income, see the value of their assets erode.

The government’s favorite 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 price index (RPI) is often used in salary negotiations.

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The pay rise was also not quite what it seemed, since most of the beneficiaries were those in management positions. Annual earnings growth for those in “unsupervised production” positions – the bottom 83% of the job market – was 2.4%.

But Wall Street’s assumption that the Federal Reserve is eager to raise interest rates is correct. The City is getting a similar message from the Bank of England that borrowing costs in the UK may need to rise faster than expected.

There is no indication that interest rates will have to go back to their pre-crisis levels. Indeed, the Fed and the Bank of England have been careful to stress that the tightening of policy will be gradual and modest. Threadneedle Street is likely looking to raise rates to around 2.5% per quarter point over the next few years, which would leave them well below the average of 5% since the Bank was founded in 1694.

Still, even that seems pretty overkill. For nearly a decade now, major developed economies have relied on heavy doses of central bank stimulus to generate growth. Interest rates had to be kept low and money printed on a large scale through the process known as quantitative easing, as finance ministries adopted austerity policies – raising taxes and cutting spending public – with the aim of reducing budget deficits.

This mixture of ultra-accommodative monetary policy and intransigent fiscal policy was a mistake. This explains why the NHS – which is experiencing its most severe budget constraints since its creation in 1948 – is struggling to keep up with demand. It also explains why the only real signs of serious inflation in recent years have been for good wine, expensive houses and old masters.

There were gasps of surprise when Leonardo da Vinci’s Salvator Mundi fetched $400 million at auction last year, more than three times the price experts had predicted, but the explanation was obvious. Low interest rates and QE have pushed up the price of assets sought after by the already affluent. This is the classic case of too much money for too few goods.

Elsewhere, it was harder to find signs of overheating. In the UK, for example, food prices have only increased by 2% over the past three years, even taking into account increases resulting from the depreciation of the pound after the EU referendum.

Trump’s tax cuts have been widely condemned and, insofar as they are pro-rich, the criticism is justified. But in two respects, they are welcome: they make growth a higher priority than the reduction of deficits and they ensure a better balance between monetary policy and fiscal policy.

Central banks have too long been the only game in town, which makes raising interest rates problematic. They want to be able to ease their policy in the event of another recession, but if they rush too much, they themselves will be responsible for the recession.

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