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It’s going to be a bumpy economic ride

The impact of America’s badly timed stimulus will ripple across the world

Saul Eslake 13 February 2018 1238 words

Challenges ahead: treasurer Scott Morrison during the Australian Economic Forum in Sydney last Friday. David Moir/AAP Image

The latest bout of global financial market turbulence has been prompted by the release of data showing that average hourly earnings of American workers rose by 2.9 per cent over the twelve months to January, the largest annual increase in nine years.

Most people, not least American workers, would have seen this as unalloyed good news — even though it was probably exaggerated by the impact of colder-than-usual weather in parts of the United States during January, and by the fact that increases in the minimum wage came into effect in eighteen states,at the beginning of the month. (The weather meant that some workers, typically those on lower pay, were unable to get to work during the week in which the monthly labour force survey was conducted, and would have been excluded from the results.) Nonetheless, the news lined up with the employment cost index (the US equivalent of Australia’s “wage price index”) released a week earlier, which rose by 2.7 per cent over the year to the December quarter of 2017, also the largest annual increase in nine years.

These data represent evidence that workers might be starting to get a slightly larger share of the American economic pie after a decade in which real wages have risen by less than 0.4 per cent per annum — well below the 1.2 per cent annual rate at which labour productivity has grown over the decade. They lend some support to the view that if the unemployment rate is low enough for long enough — and in America it’s been below 5 per cent (“full employment”) for all but one of the past twenty-one months — wages will start to move upwards more rapidly. Wages growth also appears to be starting to pick up in Germany, where the unemployment rate has been below 4 per cent for the past year.

So, although Australia’s unemployment rate is still well above 5 per cent — leaving aside the underemployment represented by people working fewer hours than they can and want to — there is some evidence for the view that the “laws of supply and demand” (as Malcolm Turnbull and Scott Morrison put it) haven’t been abolished entirely as far as the labour market is concerned.

But financial markets haven’t seen any of this as a cause for celebration. On the contrary, they’ve seen it as confirmation that the era of ultra-cheap money ushered in by the global financial crisis is drawing to a close.

For most of the past decade, the four most important advanced economy central banks — the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England ­— have been creating money in order to acquire government bonds (and, in some cases, other financial assets). Initially, their aim was to push long-term interest rates down to unprecedentedly low levels; subsequently, the aim was to keep them there, reinforcing the economic stimulus provided by cuts in short-term interest rates to zero or, in the case of the ECB and BoJ, below zero.

When central banks first began pursuing these unorthodox strategies during the darkest days of the financial crisis, some observers drew misguided parallels with the money-printing adventures of Weimar Germany or Robert Mugabe’s Zimbabwe, and concluded that the inevitable result would be higher inflation and currency depreciation. In fact, the only inflation has been in asset prices — in particular, bonds, equities and residential real estate.

As well as lowering the rate at which future cash flows (such as those generated by stocks or bonds) are discounted (thus inflating their “present value”), the search for a higher return in a low-interest-rate environment has prompted investors to take on additional risk. That has added to upward pressure on asset prices: but, as was also the case in the years preceding the financial crisis, many investors appear not to fully comprehend the extent of the additional risks that they have taken on.

The US Federal Reserve ceased its bond-buying programs in October 2014, and in October last year took the first steps on what will inevitably be a long process of gradually selling off most of the US$3.5 trillion of securities it acquired. It has also raised the federal funds rate (the equivalent of the Reserve Bank of Australia’s official cash rate) five times over the past two years, from zero to 1.25 per cent. And since the middle of last year it has been flagging its intention to lift the funds rate at least another three times this year.

Until the beginning of this month, though, investors seemed unwilling to take the Fed at its word. In particular, the US share market advanced — on a weekly if not daily basis — to successive record highs.

If anything, the risks of further upward pressure on US rates have increased in recent weeks. The US is embarked on one of the most ill-timed fiscal stimulus programs in living memory. According to the nonpartisan Committee for a Responsible Federal Budget, the corporate and personal income tax cuts enacted at the end of last year will add almost US$1.5 trillion to the US budget deficit over the next decade; the budget deal reached last week will add another US$420 billion; and the Trump administration wants to add another US$200 billion in incentives for infrastructure spending on top of that.

These measures will boost aggregate demand by a much larger margin than they are likely to lift aggregate supply — at a time when the present US economic upswing is on the cusp of becoming the second-longest on record; when the unemployment rate is lower than it’s been at any time since the late 1960s (apart from a few months at the turn of the century); when the US working-age population is growing at its slowest rate since the end of the second world war; and when GDP is already above its “potential” level (according to the Congressional Budget Office).

All up, the result is less likely to be faster growth in the US economy than to be some combination of higher US inflation and a larger US current account deficit. This will increase the risk not only of higher US interest rates, but also of more protectionist US trade measures (something which, for all the Trump administration’s rhetorical bluster on that score, it has thus far largely eschewed).

The big risk here — for the US, and for the rest of the world, including Australia — is not a replay of the financial crisis of a decade ago. There is no compelling reason to think that the banking system of any advanced economy is on the edge of an abyss similar to the one into which they fell in 2008.

If there’s a parallel from recent history, it’s more likely to be the “tech wreck” of 2000, in which irrational exuberance on the part of equity investors played a key role, as did rising interest rates at the end of a long period of economic growth. But that incident had a fairly mild impact on the US and world economies, not least because the US budget was in surplus at the time, and the Federal Reserve had room to move in order to counter the ensuing downturn. Policy-makers have far less room to move today.

So, to adapt Bette Davis’s response, in All About Eve, to the question “Is it over, or is it just beginning?” — “Fasten your seatbelts: it’s going to be a bumpy ride.” •

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