March 1, 2018 Patrick Oliver-Kelley

Volatility is back. With a vengeance. The stock market rose steadily without a sell off until it abruptly ended in the second week of February, when the bottom fell out. Then resumed its progress from a lower level. Wage growth accelerated; the VIX, an investor expectation barometer, spiked from 14 to 37- an alarm bell high. The world nerves frayed. Implying that a transition is underway where growth causes inflation to replace stagnation as investors’ biggest fear. This shift is being complicated by an extraordinary gamble in the US. The enacted tax cuts are adding a hefty fiscal boost to juice up an expansion which is already mature. Public borrowing will double to $1 trillion, or 5% of GDP. The team steering this experiment is the least experienced in recent memory: Trump and his new Fed Chairman. Boom or Bust it is going to be a wild ride.

The world economy continues in fine fettle, buoyed by a synchronized acceleration in America, Europe, and Asia. Collateral damage to other markets was limited. Yet this episode of correction does signal what may lie ahead. The loose money policy is being dismantled. Stock markets are in a tug of war between strong profits, which warrant higher prices and higher bond yields which depress the present value of earnings. Tension is the return of monetary policy to normal conditions. What is not inevitable is the scale of the US’ impending fiscal bet. Economists reckon that Trump’s tax reform will jolt growth at most 0.3%. And Congress is about to boost government spending. The mood of fiscal insouciance in Washington DC is troubling. We are being more profligate than at any time since 1945.

This cocktail of expensive stock market, maturing business cycle and fiscal largesse would test the mettle of any experienced policymaker. Instead the policy is being bought by people who claim deficits do not matter. And the Fed has a brand-new boss who has no formal experience in monetary policy.

We must get to grips with our fiscal deficit otherwise, interest rates will soar. Mr. Powell must steer between two opposite dangers: Dovish where he hesitates to gradually tighten rates to avoid creating a bubble; the other is to tighten too tight, too fast which would be a mistake. First, it is far from clear if the economy is at full employment; second, the risk of a sudden burst of inflation is limited; Third, there are sizeable benefits to letting the labor market tighten further.

The fiscal stimulation of the scale that Trump is putting in place is poorly designed and recklessly large. Financial market Volatility will be the new normal. Hopefully the Fed will not lose its head.

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