Autumn’s Known Unknowns

In the United States, three sources of policy uncertainty will come to a head this autumn. For starters, it remains unclear whether the Federal Reserve will begin to “taper” its open-ended quantitative easing (QE) in September or later, how fast it will reduce its purchases of long-term assets, and when and how fast it will start to raise interest rates from their current zero level. There is also the question of who will succeed Ben Bernanke as Fed Chairman. Finally, yet another partisan struggle over America’s debt ceiling could increase the risk of a government shutdown if the Republican-controlled House of Representatives and President Barack Obama and his Democratic allies cannot agree on a budget.

The first two sources of uncertainty have already affected markets. The rise in US long-term interest rates – from a low of 1.6% in May to recent peaks above 2.9% – has been driven by market fears that the Fed will taper QE too soon and too fast, and by the uncertainty surrounding Bernanke’s successor.

So far, investors have been complacent about the risks posed by the looming budget fight. They believe that – as in the past – the fiscal showdown will end with a midnight compromise that avoids both default and a government shutdown. But investors seem to underestimate how dysfunctional US national politics has become. With a majority of the Republican Party on a jihad against government spending, fiscal explosions this autumn cannot be ruled out.

Uncertainties abound in other advanced economies as well. Germany’s general election appears likely to produce a repeat of the current government coalition of Chancellor Angela Merkel’s Christian Democratic Union and the Free Democrats, with opinion polls suggesting that a grand coalition between the CDU and the Social Democrats is less likely. In the former case, current German policies toward the eurozone crisis will not change, despite austerity fatigue in the eurozone’s periphery and bailout fatigue in its core.

Political risks in the eurozone’s periphery include the collapse of Italy’s government and a fresh election as a result of former Prime Minister Silvio Berlusconi’s criminal conviction. Greece’s ruling coalition could collapse as well, and political tensions may rise even higher in Spain and Portugal.

On monetary policy, the European Central Bank’s forward guidance – the commitment to keep interest rates at a low level for a long time – is too little too late and has not prevented a rise in short- and long-term borrowing costs, which could stifle the eurozone’s already-anemic economic recovery. Whether the ECB will ease policy more aggressively is also uncertain.

Outside of the eurozone, the strength of the United Kingdom’s recovery and the Bank of England’s soft forward guidance have led to similar “unwarranted” increases in interest rates, which the BoE, like the ECB, seems unable to prevent in the absence of more muscular action. In Japan, the policy uncertainty concerns whether the third arrow of Abenomics – structural reforms and trade liberalization to boost potential growth – will be implemented, and whether the expected rise in the consumption tax in 2014 will choke economic recovery.

In China, November’s Third Plenum of the Communist Party Central Committee will show whether China is serious about reforms aimed at shifting from investment-led to consumption-led growth. Meanwhile, China’s slowdown has contributed to the end of the commodity super-cycle, which, together with the sharp rise in long-term interest rates (owing to the scare of an early Fed exit from QE), has led to economic and financial stresses in many emerging-market economies.

These economies – the BRICS (Brazil, Russia, India, China, and South Africa) and others – were overhyped for too long. Favorable external conditions – the effect of China’s strong growth on higher commodity prices and easy money from yield-hungry advanced-economy investors – led to a partly artificial boom. Now that the party is over, the hangover is setting in.

This is especially true in India, Brazil, Turkey, South Africa, and Indonesia, all of which suffer from multiple macroeconomic and policy weaknesses – large current-account deficits, wide fiscal deficits, slowing growth, and above-target inflation – as well as growing social protest and political uncertainty ahead of elections in the next 12-18 months. There are no easy choices: defending the currency by hiking interest rates would kill growth and harm banks and corporate firms; loosening monetary policy to boost growth might push their currencies into free-fall, causing a spike in inflation and jeopardizing their ability to attract capital to finance their external deficits.

There are two major geopolitical uncertainties as well. First, will the looming military strikes by the US and its allies against Syria be limited in scope and time, or will they trigger a wider military confrontation? The last thing that a fragile global economy needs now is another round of peak oil prices.

Second, a year ago the US convinced Israel to give its non-military approach to Iran’s nuclear-weapons ambitions time to bear fruit. But, after a year of economic sanctions and negotiations with no result, Israel’s patience on what it regards as an existential issue is wearing thin. Even short of an actual military conflict – which could double oil prices overnight – the resumption of saber-rattling by Israel and the war of words between the two sides could lead to a sharp rise in energy costs.

The looming known unknowns are plentiful. Some outcomes may be more positive, or at least less damaging, than expected. But the realization this autumn of even some of the risks described here could derail the global economy’s still-wobbly recovery. And the meta-risk of policy mistakes and accidents remains very high.

Copyright: Project Syndicate, 2013.
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