What could possibly go wrong?
16 January 2018
The global economy is sailing along nicely, with few signs of the cyclical upswing that took hold last year fading. This momentum is reflected in resolutely upbeat consensus growth forecasts (see Chart 1). However, what if economists have become complacent? Here, we conceive four developments capable of delivering a radically different outcome for 2018, without significantly altering our baseline growth assumptions. First, the shift toward tighter monetary policy is interpreted as a genuine tightening cycle. Second, the dollar rises more than 5%. Third, the low volatility environment comes to an end. Finally, complacency around political risk ends.
Like any good disaster movie, this series of events appears unlikely but is not as far-fetched as to be unconceivable. The benign rate hike cycle view is premised on a world of weak inflation responsiveness. Policymakers would have to react differently if inflation materially surprised to the upside, unsettling consensus thinking on a slow and steady normalisation. A more aggressive tightening cycle in the US could push the dollar higher, as could the effect of repatriation of corporate profits in the wake of the Republican tax plan, or a rapid reversal of short dollar positioning. In this environment, concern would quickly shift to the emerging world and the impact of a stronger dollar on commodity exports and general liquidity conditions. However, the pinch could also be felt closer to home. Indeed, a broader financial shock is conceivable if investor infatuation with developed market bonds soured. Sharp increases in market interest rates, on account of higher term premia would provide an additional drag, and potentially lead to credit concerns in more leveraged sections of economies. Policymakers would face a difficult trade-off between growth and inflation in this environment and would likely only react once it was very clear that financial stress was affecting the real economy. These policy responses would be even more complicated if populist politics, such as protectionism, transition from risk to reality. Of course, the point of this thought experiment is not to invent an Armageddon scenario but to highlight how individual judgements can quickly snowball into rather extreme events. The economic winds are set fair but we remain vigilant about approaching weather fronts.