Rising risks to the global economic outlook

One has to be struck by the basic disconnect between current global financial market prices and underlying global economic and political fundamentals. Similarly one has to be struck by how little attention the Federal Reserve seems to be paying to rising global risks in its assessment of the U.S. economic outlook. For at a time that a confluence of unusually serious global economic and political risks are rearing their ugly heads, global equity and credit markets reach new highs. Similarly, far from removing the proverbial punchbowl as the party gets going, the Fed has given the markets the green light to continue partying by remaining in denial about growing global economic and political risks.

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Among the more serious risks that both the market and the Fed seem to be downplaying relate to the longer-run security of Middle East oil supplies. This is all the more surprising considering the tectonic changes that appear to be occurring in the Middle East. After all, the U.S. appears to have lost the political willingness to impose order abroad at the very time that Iraq, OPEC's second-largest oil producer, appears to be splitting apart along sectarian lines. Meanwhile, Islamic fundamentalism appears to be on the rise, Iran proceeds with its nuclear program, and Syria's civil war continues unabated.

One would have thought that markets would have been particularly concerned about the risk of an oil price shock since it is one to which the Federal Reserve would have difficulty in responding. For any significant increase in international oil prices above their present already elevated levels would both hamper an already weak economic recovery while at the same time increasing the risk of un-anchoring inflationary expectations. In those circumstances, the Fed would be wary of any easing of monetary policy to support economic growth for fear of validating incipient inflationary pressures.

A second risk to which the market seems to give but fleeting attention relates to any future intensification of the Ukrainian crisis. This would seem to be particularly surprising considering both the risks that the Ukrainian crisis might pose to European energy supplies from Russia as well as the risk that further international economic sanctions on Russia could unsettle global financial markets. It would also seem surprising considering that for domestic political reasons, Russian President Vladimir Putin has every incentive to keep the Ukraine crisis on a low boil. Especially given Russia's position as Ukraine's main energy supplier, Putin certainly has the means to destabilize the Ukrainian economy.

Yet a third and perhaps even more serious longer-term risk to which both the markets and the Fed seem to be paying scant attention relates to the probable re-intensification of the European sovereign debt risk. This inattention is all the more surprising considering the mounting evidence pointing to a sputtering of the already feeble European economic recovery and to the move of the European economic periphery toward outright price and wage deflation.

It is also surprising considering the very clear indications, especially from the recent dismal European parliamentary election results, that European politics continues to become increasingly polarized and that austerity and economic reform fatigue has now firmly set in that region. In these circumstances, one would have thought that both market participants and the Fed would have agreed that it must be only a matter of time before serious questions are once again raised as to how the highly indebted European countries will ever bring those debt levels down to more sustainable levels.

This is hardly the first time that markets and the Fed have downplayed global and economic risks. However, while this might be excusable for markets that constitutionally have a short-term focus, it would not seem to be excusable for the Federal Reserve, whose very mandate is to promote economic growth and employment within an environment of low inflation. So recently after the Lehman economic crisis, the Fed's inattention to global economic and political risks and its state of denial about global market excesses is all the more difficult to understand.

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.