European Central Bank president Mario Draghi and Federal Reserve chair Jerome Powell will be the architects of the end of the second-longest period of synchronised global growth in history, according to Schroders’ Keith Wade.
In his outlook for the next two years, the asset manager’s chief economist said although the global economy is still growing pretty robustly, the best of the growth in the economy is behind it, with Draghi and Powell now in the spotlight.
“In 2020, the new chair of the Federal Reserve, Jerome Powell will end the party. He has the job of raising interest rates, normalising monetary policy in the US,” said Wade.
“We know that higher interest rates eventually slow down economies; will he go too far? Will he raise interest rates too much? Clearly that is an issue.
“The ECB are a bit behind the US of course, but they also want to end quantitative easing, and we think they will aim to do that later on this year.
He added: “They are also going to be raising interest rates, and this, we think, is going to be very difficult for them to do without maybe causing some ructions.”
The economist said inflation will also likely pick up further in the US, and given unemployment is well below the natural rate, Wade said wage growth will begin to accelerate, which will take the US economy in a more stagflationary direction as we go to 2019.
“Not only is this a big issue for the Federal Reserve but has also been made worse by [US president] Donald Trump’s fiscal policy,” Wade said.
US Unemployment rate over 10yrs
Source: FRED
“The last time we had this combination of the low unemployment and fiscal stimulus was back in the 1960s. The budget deficit during those periods was expanding as the unemployment rate was low.”
Wade added: "During the 1960s you had the fiscal expansion going on as a result of the great society project and the US ended up with a really big pickup in inflation; core inflation rose to 6 per cent then.
“I am not saying that you are going to see the same effect today as inflation expectations are well more anchored but this is a recipe for inflation.”
Notwithstanding the big gap between what the Fed has announced it will do and what the markets think he will do, Wade noted interest rates in the US are likely to go to 3 per cent and higher.
He said: “The Fed have said they are going to raise rates 3.5 per cent. The market says they won’t even raise rates to much above 2.75 per cent.
“We are much more in the camp of saying rates are going to 3 per cent or even higher, and that I think is really going to be the challenge for Jerome Powell.
“The main question to ask now is: how much does Powell has to raise interest rates to slow the economy down?”
Global interest rates
Source: Schroders
Meanwhile, in the eurozone, ECB president Mario Draghi has a real challenge on his hands in withdrawing quantitative easing, with the main issue being stopping bond yields from blowing out, said the economist.
“If you take away the ECB as a big buyer, people will suddenly focus on some of the risks in some economies, like the Italian one, for example,” the Schroders chief economist said.
“Italy is in the spotlight with the Five Star Movement coming in saying that they want to write-off $250bn of debt.
“These things do not help market sentiment, and we think that they could see quite a widening of spreads in the periphery if this is not handled very carefully.”
Indeed, after Greece, Italy has the second highest debt in the eurozone and, as investors start worrying about the Italian government’s ability to pay all that it owes, the spread between Italian and German government bond yields has recently widened sharply.
The nomination of a Eurosceptic academic Paolo Savona as finance minister by a coalition government of populist parties Five Star Movement and the League had spooked markets before being blocked by Italian president Sergio Mattarella, who then invited former International Monetary Fund official Carlo Cottarelli to form a technocratic government on Tuesday.
This prompted Italian bonds to suffer their worst day since 1992 – going up more than 300 basis points above Germany’s.
Italy 10yr bond yields
Source: FRED
When it comes to the domestic economy, the economist said the UK has gone from the top of the growth league to the bottom since the EU referendum, which has not been entirely due to Brexit, although the ongoing negotiations has had quite a dampening effect on business investment in particular.
“This has also had quite a negative effect on consumer spending; that is beginning to come through still at the moment: retail sales have been under pressure, the housing market has been under pressure,” Wade noted.
He added: “I think the prospects for the UK are still difficult. We have just downgraded our growth forecast for the year to 1.4 per cent.
“Interest rates are probably not going to rise for quite some time; certainly not in the summer as a lot of people seem to think; we think November is more likely, and then they will raise rates very slowly.”