Protectionism does not necessarily go hand-in-hand with inflation

The aggressive protectionist measures announced by the US president over the past few days have generally been perceived as a prime inflationary threat. The reasoning is rather logical. An increase in import tariffs on non-substitutable goods that enter the production processes of key economic sectors or are purchased directly by US consumers will cause the price of those goods to rise. In addition, (i) the US balance of payments is likely to deteriorate and push down the dollar, and this might be exacerbated by potential difficulties in external financing, and (ii) the rest of the world might retaliate against the announced US measures, creating a domino effect. In theory, this combination is the perfect inflationary cocktail. How then can we explain that the markets have not shown greater expectations of inflation?

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The kind of US employment report we like!

The reflation scenario that markets have been hoping for since mid-December is very sensitive. It needs just enough growth but not too much inflation, because this would run the risk of a sudden change in monetary policy. And the high valuations prevailing on the world’s stock and bond markets would probably not survive such a change. Last month’s employment report was rather negative in this regard, with a relatively mediocre rate of new job creation accompanied by an acceleration in wages. Although modest, this movement toward higher wages convinced many market observers that there was an increased risk that the Fed would raise its rates quicker than expected (for more on this topic, please see Slightly more jobs and wages in the USA, but much more risk for the bond market, dated February 2).

Today’s report was much better, maybe even good enough to suggest the dawn of a more virtuous phase of the US business cycle.

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A fall in the dollar could unleash a chain reaction

The trend in the US dollar’s exchange rate is becoming a source of concern. The dollar has lost nearly 15% of its value since the year-end 2016 high it reached following the election of Donald Trump, and it might now fall toward its 2011 and summer 2014 levels, i.e. 10-15% below its current value.

Confidence in the US administration is withering, and this is largely responsible for the exchange-rate situation. In addition, doubts are accumulating about how much latitude Jerome Powell, the future Fed chairman, will have to exercise his mandate, as he will be operating in the shadow of an invasive executive branch and increasingly demanding financial valuations. The risk of a dollar crash, which would consist of a significant, across-the-board fall in the currency’s value, is real.

What kind of impact could we expect if this were to occur?

The US dollar occupies such an important position in the international economic monetary and financial system that the consequences of a potential pronounced drop in the dollar are particularly complex to analyze. It is the number one reserve, payment and financing currency – both bank and non-bank – and it is used as a peg by more than 70 countries. The size and strength of the US economy as well as the accumulation of deficits vis-à-vis the rest of the world have made dollars abundant outside the United States and contributed to a level of supremacy that neither the euro nor the yuan can challenge. At the end of 2017, the US economy’s net external debt to the rest of the world was nearly $8 trillion, of which $6.4 trillion was financed by treasury bonds held by non-residents the world over. The presence of the US dollar in every nook and cranny of the world economy does not make the analysis any easier. What would be the net effect, for example, of a drop in the dollar on the Chinese economy? Chinese companies would become less competitive, but their debt, much of which has been contracted in dollars in recent years, would decline. At the same time, the country’s war chest of $3.1 trillion in currency reserves, half of which is invested in US treasury bonds, would erode fast... Lire la suite…

Scenario 2013-2014: The Financial Crisis, Act III…and Epilogue?

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New round of central bank liquidity injections worldwide

  • The U.S. economy can’t do without Fed support
  • The euro area is out of recession, but bank sector and sovereign issues remain
  • The Fed, BoJ, BoE and ECB continue to nurse ailing economies

Continued low interest rates are not enough to dispel emerging risks

  • The momentum driving global trade has been undermined for the foreseeable future
  • China can no longer act as the global engine of growth
  • Foreign exchange rate adjustments appear inevitable

Is inflation, end-point of the financial crisis, around the corner? 

  • New round of liquidity injections, currency crises, geopolitical tension, labor unrest…
  • … Inflation remains the most likely scenario, but the path ahead is unclear