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.”
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.
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.