Speaking in June at the annual European Central Bank forum in Portugal, Federal Reserve Chair Jay Powell stuck to his mantra that risks to the US economy are balanced and that US financial vulnerabilities remain moderate. He did so despite clearly gathering storm clouds in the global economy.
In assessing risks to the US economy, Powell should be asking two questions: how much damage would the US economy take if any of the external risks were to materialise, and how great is the probability that those risks will materialise?
Had Powell asked those two questions, he might not have remained as sanguine as he appears to be. Instead, he might have focused on the following three external risks and the threat they pose to the US and global economies.
The first is the deteriorating economic and political situation in Italy, the euro area’s third largest economy and the world’s third largest sovereign debt market. After the formation of an unstable populist government in Rome, whose policy agenda places it on a clear collision course with its European partners, the chances of an Italian crisis within the next six months have risen appreciably.
The new government is highly unlikely to adopt policies that would put the country on a faster growth path. Such measures are necessary to address Italy’s serious public debt and banking sector problems. These troubles are compounded by the winding down of the ECB’s asset purchase programme and signs of an overall European economic slowdown.
It would be an understatement to say that an Italian collapse would constitute a seismic shock to the US and global economies. The euro would not survive in its present form if Italy was forced to exit the arrangement. It is also difficult to imagine that an Italian default on its $2.5tn public debt would not set off a full-blown European banking crisis. That, in turn, would send shock waves throughout the global economy.
The second major external risk that Powell is downplaying is Sino-US trade tensions. President Donald Trump’s administration has ratcheted up import tariffs on China, prompting a novel response from Beijing. Rather than imposing retaliatory tariffs against US companies, China is offering greater market access to their competitors in other parts of the world, portraying itself as a champion of trade openness and subverting Trumpian protectionism.
Circumstances are not helped by the dimming prospects of a successful conclusion to North American Free Trade Agreement negotiations. There besides, Trump is threatening Europe’s car sector with punitive tariffs, and global financial markets continue to be riled by the risk of a global trade war amid a return to beggar-thy-neighbour policies.
The third risk is the possibility of an abrupt slowing of the Chinese economy, as well as of those of other large emerging markets. These countries are trying to operate in a less open global economy while also struggling with the consequences of US monetary policy normalisation. Emerging markets now constitute more than half of the global economy, according to the International Monetary Fund, and their debt levels are higher than they were on the eve of the 2008 Lehman Brothers bankruptcy. Moreover, the currencies of many emerging markets are weakening as capital flows dwindle in response to higher US interest rates.
In setting US monetary policy, Powell should of course focus on fulfilling the Fed’s dual mandate of high employment and low inflation. However, by choosing to downplay external risks that have a reasonable chance of materialising and disrupting the US economy, he reduces the chances of the Fed delivering on its domestic mandate.
Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.