The hopes and uncertainty of a new era

A festive spirit has swept Wall Street as investors anticipate tax cuts for both households and companies, and to a lesser extent, greater spending, notably on infrastructure. In contrast, the bond market has slumped: Treasury yields have risen sharply, in part because the Fed is expected to raise key rates at a time when a likely fiscal stimulus is expected to boost the US economy, even as it verges on full employment, but also because the world has become more uncertain. There is less visibility over inflation and monetary policies, which has led to a steeper yield curve.

It will be interesting to see to what extent expectations of an upcoming fiscal impulse will be reflected in the behaviour of economic agents in the weeks ahead. The Conference Board’s household confidence index rebounded in November, and the present situation index has risen to the highest level since July 2007. Washington’s new budget policy shift will also be welcomed in Paris, especially at the OECD’s Chateau de la Muette headquarters. In its Global Economic Outlook released this week, the OECD states that “in order to ensure the exit from the low-growth equilibrium… accommodative monetary policy needs to be complemented by enhanced collective use of fiscal and more ambitious structural policies and avoidance of more widespread trade protectionism”. The same theme can be heard in Brussels, where the European Commission recently urged the eurozone member countries to adopt an “overall fiscal policy” with a moderately expansionary fiscal stance.

There is a real risk that the hopes fuelled by these intentions and arguments could later prove to be unreasonable, given the long list of doubts and questions. Concerning the United States, how big will the fiscal stimulus be? What will be the mix between tax cuts and spending increases? What will be the induced economic impact – the famous “multiplier” as the economists say – of tax cuts and spending increases? What about the timing of these measures? How will the dollar and long-term rates react? Especially knowing that a strong rise in either would put a damper on the economy, even if the Federal Reserve takes no action. As to the other countries, notably in Europe, how much fiscal manoeuvring room do they really have? What about their political determination?

All in all, the United States has clearly entered a new era with a new mix of monetary and fiscal policies that will require some monetary policy adjustments. This is likely to have international repercussions, notably for the emerging countries, via global trade, exchange rates (stronger dollar) and financing conditions (higher long-term rates in the US should drive up yields in the emerging countries). Yet some countries seem more vulnerable than others: Hungary, Malaysia, Taiwan and South Korea seem to be more exposed, unlike China, Russia, Brazil, India and Indonesia. The impact on the eurozone is unlikely to be as strong, with the euro approaching parity against the dollar in 2017, and with a more moderate upturn in long-term rates relative to the US, due to a more sluggish economic environment and a persistently expansionary monetary policy. Yet even in the eurozone, investors are gradually preparing for a new era, certainly from a monetary perspective (at some point, the ECB will have to scale back its securities purchases as part of QE), and possibly even in terms of fiscal and structural policies, depending on the outcome of elections.

William De Vijlder

Economic Research Director, BNP Paribas

29 November 2016