Geopolitical upheaval poses a unique obstacle for the Fed

Geopolitical upheaval poses a unique obstacle for the Fed
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Normalizing interest rates after so many years of ultra-easy monetary policy was never going to be easy for the Federal Reserve. This appears especially to be the case in today’s difficult global political environment.

As if to underline this point, earlier this month, Italy, the eurozone’s third-largest economy, had a highly disappointing electoral result.

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Meanwhile, later this year, major emerging market economies like Mexico and Brazil are due to go to the polls. Those elections are all too likely to produce electoral results that also will be very unfavorable for their domestic economies.

 

A basic challenge facing the Fed is that many years of highly unorthodox monetary policy have resulted in global financial markets being priced to perfection. In particular, interest rates to risky borrowers around the world have dropped to levels that presuppose that those borrowers will not face any major political or economic setbacks anytime soon.

In a troubled geopolitical context, this leaves the Fed with the narrowest of paths to tread. It needs to raise interest rates to keep inflation well-contained. However, it needs to do so without causing disruptive credit market repricing that could roil global financial markets.

Recent developments in Italy, the world’s third-largest sovereign bond market with more than $2.5 trillion in outstanding debt, illustrate the difficult challenge now facing the world’s major central banks.

Ample global liquidity and European Central Bank bond-buying has allowed the Italian government to borrow at 2 percent despite Italy’s public debt mountain, its shaky banking system and its sclerotic economy. Strikingly, this is below the corresponding 3-percent rate at which the U.S. government now borrows at.

Now, at the very time that the Fed might be forced to raise interest rates at a faster pace than it was planning, and as the ECB is contemplating ending its bond-buying program, a storm appears to be gathering in Italy’s troubled political economy.

In the March 4 elections, the country’s centrist political parties suffered a beating at the hands of populist parties, which together gained more than 50 percent of the vote. This makes it all too likely that the next Italian government will be headed by either the Five-Star Movement or The League.

Both of those parties are not known be believers in budget disciple or in economic reform. Nor are they thought to be enthusiastic supporters of the European project.

Sadly, Italy would seem to be only the first of a number of systemically important countries that might face political setbacks in 2018 that could have large adverse domestic economic consequences. In the scheduled July 2018 Mexican presidential election, the left-leaning populist Andres Manuel Lopez Obrador is heavily favored to win at the polls. 

This could be highly unsettling to the Mexican investment climate in that it could complicate the successful conclusion of North American Free Trade Agreement (NAFTA) negotiations with the United States, and it could raise the prospect of a market-unfriendly domestic investment climate.

Similarly one has to be concerned about the likely economic fallout from October’s scheduled general elections in Brazil, South America’s largest economy.

At a time that the country’s public finances are on an unsustainable path, as evidenced by a budget deficit of close to 9 percent of GDP, the establishment political parties have been irreparably discredited by the Petrobras scandal.

This makes it all too likely that Brazil will find itself saddled with a populist president of one form or another who will be ill-equipped and unwilling to tackle the country’s serious public finance issues.

All of this leaves Fed Chairman Jay Powell with an unenviable challenge. He must find a way to raise interest rates to prevent President TrumpDonald John TrumpDemocrats ask if they have reason to worry about UK result Trump scramble to rack up accomplishments gives conservatives heartburn Seven years after Sandy Hook, the politics of guns has changed MORE’s expansive budget policy from causing the U.S. economy to overheat.

Yet he must do so without unsettling troubled countries abroad, which could roil over-stretched global financial markets. For which reason, we have to wish Powell the best of luck in meeting that daunting challenge.

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.