Moral Hazard. It sounds like the name of a failed town in a Clint Eastwood western. We all live there now. – The Wall Street Journal (2008)
In the past several weeks the world’s financial markets have re-entered into higher volatility mode as the ongoing trade dispute between the two largest economies is dashing hopes of speedy improvement in US-China relations. The uncertainty afflicting the markets is further exacerbated by the contradictions between the Trump camp and the Fed, with increasing trade tensions forcing the Fed to accommodate the negative effects on the US economy through monetary policy easing. The problem is that the Fed may not be ready to fully compensate the effects of escalations in trade tensions and with good reason.
August is never an easy month for Russia’s markets, but this time surges in volatility started to afflict the global markets across the board. The fear of greater uncertainty surrounding the trade dispute between the US and China is getting transformed into increasing conviction in the markets of an onset of recession as symbolized in the inversion of the yield curve. As the inversion materialized in mid-August and the yield on the 2-year US Treasuries exceeded that of the 10-year yield the markets dived – along with the developed and EM stock indexes, commodity prices as well as EM currencies joined the steep decline.
Recessionary fears have clearly intensified as more signs of the likely global slowdown are emerging in different parts of the globe. Across the three main centers of the world economy, namely the EU, US and China, statistics and business confidence indicators point downwards. In the EU the more than 5% drop in German industrial production is feeding into the broader GDP growth slowdown, with Italy gearing up for the confidence vote for the government, while Britain is yet to finalize its Brexit travails. In China industrial production also took a hit on the back of the trade restrictions imposed by the US, while the US is set to follow a lower growth trajectory on the back of trade tensions and lower investment growth given weaker markets and business confidence.
Against the backdrop of the swings in the financial markets all hopes are squarely focused on the largest Central Banks and in particular on the Fed to save the day. The bad news is that the longer the sequence of trade-related shocks afflicting the markets, the less the altruistic zeal of the Fed to bring back the markets in order. Part of the reason for the reluctance to signal more rate cuts ahead may be the problem of “moral hazard” – the same problem that arguably brought the onset of the 2008 financial crisis when the US authorities chose not to save Lehman Brothers. The “moral hazard” problem came to be associated with greater incentives for irresponsible/speculative behavior coming on the back of measures to provide support to economic agents pursuing high risk strategies.
This time around the “moral hazard” problem is of a different kind – the more readiness exhibited by the Fed in monetary loosening to neutralize the adverse effects of trade tensions, the greater the scope to indulge in economic policy excesses, including in the trade sphere going forward. Given the recent dynamics in the global markets anything short of an explicit commitment to more cuts in the near term will be taken by the markets negatively as an insufficient, half-hearted response to support the markets.
Another deterrent for the Fed in effecting a monetary stimulus is the threat of the rekindling of inflationary pressures. Indeed, the pattern characterized by increasing import tariffs and disruption of value added chains together with competitive devaluations of currencies is likely to give a boost to cost inflation. The US core inflation reading in this respect points to a pick up in price growth to over 2%. The resulting menace facing the global economy may be stagflation that may render subsequent fiscal expansion as well as rate cuts to support growth more problematic.