The American economic plan will harm the global economy and global stock markets

The European Central Bank began easing interest rates on Thursday, cutting its benchmark interest rate by 0.25%. The move is not only a sign of confidence that the euro zone is in the final stages of its battle with inflation, but also a signal of concern that the economy needs a small boost to continue progressing. Investors and economists expect the Fed to follow suit and cut interest rates in September. Thus, the story goes, central banks around the world will begin a coordinated slide toward a soft landing — a perfect calibration for this push-and-pull between fighting inflation and evading recession.

The truth is, reality has been making fun of experts’ assumptions all year. Wall Street started the year expecting inflation to subside, the economy to slow to a more subdued pace of growth, and up to six interest rate cuts from the Federal Reserve. Instead, inflation data was consistently hot, and the strength of the US economy defied expectations. This combination means there is a good chance that the cut Wall Street is demanding in September will never materialize.

“It will definitely be an interesting summer,” Tamara Pesek-Vasilev, a senior economist at Oxford Economics, told me. Its basic argument is that everything will go according to plan, but there are some caveats: “The Fed has proven its ability to fight any kind of financial stability issue. But what if services inflation continues to rise suddenly over the summer? It becomes clear that they They can’t even cut in September.”

If the Fed does not cut interest rates next fall, America’s high-interest-rate regime will be far behind the rest of the world. Any difference between the United States and the rest of the world would send a strange wave of money to America’s shores. This sudden increase in liquidity could in turn add liquidity to our financial system at a time when the Fed is trying to drain it and raise prices throughout the economy. This would make it more difficult for the Fed to ease monetary policy, which would further diverge US policy from the rest of the world. Think of it as a treadmill that stands in the way of a smooth and smooth descent into the world.

Over time, this may add volatility to already volatile markets. Here in the US, stocks move depending on the mood – after a week, Wall Street thinks we are headed for stagflation; The next day, you think a soft landing is coming. This divergence in interest policy, over time, has the potential to bring the same frenetic energy to the currency markets.

Carrier nation

Wind is the result of an imbalance: the movement of air from areas of high pressure to areas of low pressure. The greater the pressure differences, the faster the wind blows. The same principle applies to global cash flow – investors chase imbalances, and sometimes things get messy in the process.

The United States already has somewhat higher interest rates than other countries – the Federal Reserve’s benchmark interest rate is 5.25%-5.50%. These differences allowed Wall Street to achieve what is called “Bear trade“: Investors borrow money from a country with low interest rates, invest it in bonds from a country with high interest rates, and pocket the difference. In this case, that means moving money from the rest of the world and buying US assets, especially government bonds

What looks like a death blow to Wall Street is not good news for either the United States or the global economy.

This trade has been hot since the start of the year – investment banks like JPMorgan and UBS recommend it to clients, and a Bloomberg index based on selling lower-yielding G10 currencies and buying higher currencies has already returned 7% this year. The Institute of International Finance reported that in May alone, emerging markets excluding China — where interest rates are also higher — saw bond market inflows of $10.2 billion, mostly due to investors benefiting from carry trades such as Sell ​​Japanese Yen To buy Mexican pesos. These deals are “everywhere,” Peter Shavrik, global strategist at RBC Capital Markets, told Bloomberg. The greater the divergence between interest rates, the more attractive the march of money from weak to strong becomes.

What looks like a death blow to Wall Street is not good news for either the United States or the global economy. As economies in Europe and elsewhere lose momentum, absorbing more money from these economies will tighten financial conditions as they try to avoid a slowdown – especially in important regional data such as… German industrial production, which has become soft recently. It would also weaken the euro, which would make it harder for the continent to import the energy it needs to fuel its economy and make it more expensive to buy American goods. And in Asian economies, where interest rates are already much lower than in the United States, things could get even messier.

“We expect Japan and South Korea to face challenges in balancing monetary policy to maintain stability as the dollar strengthens,” Nigel Green, CEO of DeVere Group, a global wealth management firm, told me. “I would not be surprised if policymakers feel the need to intervene in currency markets or adjust interest rates to manage these effects.”

For the United States, the flow of more money to America’s shores has the opposite effect of what the Fed wants to achieve: it pushes asset prices higher and eases financial conditions. In other words, it makes it harder for the Fed to fight inflation that angers consumers.

“There are legitimate concerns that this influx of capital into the United States will increase liquidity, leading to higher asset prices and inflationary pressures, making it more difficult for the Fed to cut interest rates,” Green said. “Increasing liquidity could lead to inflationary pressures, which the Fed may need to counter by maintaining or even raising interest rates.”

As Green mentioned, there is a way the Fed can fight back: raise interest rates further. But raising interest rates further could end up breaking the back of the hitherto strong American consumer and sending us into recession. These are the same calculations made by the European Central Bank, although the EU slowdown has been more pronounced. Given these downsides, the Fed is unlikely to raise interest rates, which would create the perfect market for a carry trade boom. As long as US data remains volatile – indicating flat inflation one day and then falling inflation the next – this carry trade money will eventually end up moving around the economy. This is the dynamic that central banks in countries already on the path to lower interest rates will be monitoring. They are already seeing growth slowing, and on top of that, money will be withdrawn to the US, where data was relatively strong during the first half of the year. The transfer trade exploits disruptions between global economies that prevent our policies from coordinating. We are in the early stages, but the longer this goes on, the greater its impact will be. For Wall Street, this means a summer of awakening. For economists, this means that the picture of our economy that they are trying to piece together with contradictory data is becoming murkier. It is a time of increased uncertainty.

Sticky landing

There is of course hope that this difference is only temporary. If the United States suddenly starts printing weak economic data, that would accelerate the Fed’s move to cut interest rates. There are signs that EU inflation is more persistent than policymakers would like, which could slow the pace of cuts enough to enable America to catch up.

There are already signs of a slight slowdown in the red-hot US economy: the US household savings rate is at its lowest level in sixteen months, disposable incomes have made only modest gains, and the amounts people have to pay on credit balances have risen. The hot job market has cooled, and job opportunities have returned to pre-pandemic levels. But not all indicators tell a soft landing story. On Friday, the May jobs report showed the country created 272,000 jobs — far more than the 182,000 expected. Volatile data continues in the US.

There are limits to how far you can move away from the United States.

On the other side of the Atlantic, there are signs that inflation in the UK and EU may be more difficult than policymakers expected. The EU inflation rate rose slightly to 2.6% in May, which surprised the ECB but was not shocking enough to stop the interest rate cut in June. In the UK, stubborn services inflation, which reached 5.9% for April, may give the Bank of England reason to pause. This suggests that the EU and the US are moving more in tandem than this policy lag suggests, and that the current policy divergence will remain brief, Oxford Economics’ Vasiliev told me. Even the Bank of Canada, which cut its benchmark interest rate to 4.75% from 5% last week, is cautiously optimistic that the disruption will be temporary. “There are limits to how far we can move away from the United States, but we are nowhere near those limits,” Bank of Canada Governor Tiff Macklem said at the Bank of Canada’s recent meeting. Not even close…yet.

This rosy forecast is no guarantee: Wall Street still expects three cuts this year from the European Central Bank and the Federal Reserve Bank of England. Even in segments as small as 0.25%, three cuts would create divergence for traders to exploit. If September comes and it’s still hot in the US, this exploitation could continue throughout the year, exacerbating conditions that make monetary policy out of sync. That nagging sound you’ll hear all summer long is the sound of Wall Street gobbling money from Europe, Canada, the UK, and East Asia into US markets. Policymakers will have to recalibrate. That doesn’t mean we won’t commit to a soft landing — especially if this turbulent moment is brief — it just increases the odds of a bumpy ride until we get there.

Lynette Lopez He is a senior correspondent at Business Insider.