Christine Lagarde had good news to tell when she turned up in Davos three weeks ago to announce the International Monetary Fund’s latest economic forecasts. The global economy was doing better than expected pretty much everywhere, the IMF’s managing director said.
There was, though, another message, a warning not to get too carried away about a recovery that had left out large numbers of people and was not based on particularly solid foundations. “There is also significant uncertainty in the year ahead,” Lagarde said. “The long period of low interest rates has led to a buildup of potentially serious financial sector vulnerabilities.”
The IMF does not always get it right but on this occasion Lagarde nailed it. Over the past week, shares on Wall Street have fallen sharply, with the Dow Jones recording 1,000-point plus declines 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, the markets came down for the same reason as they rose steadily throughout 2017: because of the brighter economic news Lagarde reported. The trigger for the sell-off was a US labour market report, which showed more jobs being created, wages going up and unemployment at 4.1%.
Most Americans would struggle to work out why this would cause share prices to plunge. After all, unemployment has been coming down steadily for years, during which time US workers have struggled to make ends meet. Annual earnings growth is still running below 3%.
But from the perspective of Wall Street, these are now seen as unwelcome developments. In 2017, the financial markets bought shares because they thought the US was in for a prolonged period of strong growth, weak inflation and low interest rates.
The moment the jobs’ report came out it was as though a switch had been flipped. Markets now viewed stronger US growth with trepidation because they thought it would result in higher inflation and tougher action from the US central bank, the Federal Reserve. Donald Trump’s package of tax cuts, finally pushed through Congress at the end of last year ceased to be the growth-boosting, productivity enhancing benefit to the economy it had been in 2017 and suddenly became a means of overheating the economy and driving up the US budget deficit. Because Washington would need to borrow more to bridge the gap between its spending and its tax revenue, the assumption was that interest rates would need to rise.
As it happens, some of Wall Street’s assumptions are questionable. Take the idea that America is running at full employment, for example, where the 4.1% jobless rate masks the fact that labour market participation has yet to get back to where it was at the start of the Great Recession a decade ago. America’s employment rate is currently just over 60% – 3 percentage points lower than it was in 2008.
Nor was the rise in wages quite all that it seemed, since most of the beneficiaries were those in senior positions. Annual earnings growth for those in “production non-supervisory” positions – the bottom 83% of the jobs market – was 2.4%.
But Wall Street’s assumption that the Federal Reserve is keen to raise interest rates is correct. The City is getting a similar message from the Bank of England, that UK borrowing costs might need to go up faster than hitherto expected.
There is no suggestion that interest rates will need to rise to their pre-crisis levels. Indeed, both the Fed and the Bank of England have been at pains to point out that the tightening of policy will be gradual and modest. Threadneedle Street probably envisages raising rates to around 2.5% in quarter-point steps over the coming years, which would leave them well below the 5% average since the Bank was founded in 1694.
Yet even this looks quite a stretch. For almost a decade now, the major developed economies have relied on heavy doses of stimulus from their central banks to generate growth. Interest rates have had to be kept low and money printed on an enormous scale through the process known as quantitative easing because finance ministries have adopted austerity policies – higher taxes and cuts in public spending – in an attempt to reduce budget deficits.
This mix of ultra-loose monetary policy and hardline fiscal policy was a mistake. It explains why the NHS – experiencing its toughest budgetary constraints since it was founded in 1948 – is struggling to cope with demand. It also explains why the only real signs of serious inflation in recent years have been for fine wine, expensive houses and old masters.
There were gasps of surprise when Leonardo da Vinci’s Salvator Mundi was knocked down for $400m at auction last year, more than three times the price experts had predicted, but the explanation was obvious. Rockbottom interest rates and QE have driven up the price of assets sought by the already well off. It has been the classic case of too much money chasing too few goods.
Elsewhere, it has been harder to find signs of over-heating. In the UK, for example, food prices have risen by just 2% in the past three years even accounting for the increases that have resulted from the pound’s post-EU referendum depreciation.
Trump’s tax cuts have been widely condemned and, to the extent that they are pro-rich, the criticism is justified. But in two respects they are welcome: they make growth a higher priority than deficit reduction and they provide a better balance between monetary and fiscal policy.
Central banks have for too long been the only game in town, which makes raising interest rates problematical. They want scope to ease policy in the event of another recession, but if they are too hasty they themselves will be responsible for the downturn.