When the U.S. goes it alone, what does the rest of the world do?

By Ross Finley

LONDON (Reuters) – Before the financial crisis hit more than a decade ago, the easy way to test the global outlook was to apply the maxim that when the U.S. sneezes the rest of the world catches a cold.

Much more relevant now is any potential illnesses from a bout of inward-looking U.S. policy, namely imposing tariffs on steel and aluminum imports while keeping natural trading allies in limbo on whether or not it applies to them.

So far, nobody has a clear diagnosis but financial markets have smelled a whiff of change in recent weeks. Conventional wisdom, simple maths and plenty of recent evidence shows reduced global trade leads to reduced economic activity.

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That suggests the United States, even though its share of the world’s economic output shrinks as emerging markets keep expanding more quickly, could give the world economy a lot more than a cold, depending on how far the White House wants to push it.

After an extended period of ceding ground to most currencies, the U.S. dollar has surged in recent weeks as it became increasingly apparent to traders and investors that in more ways than one, the U.S. appears to be going it alone.

Faced with a mostly solid expansion, very low unemployment and massive tax cuts just passed by Congress before the turn of the year, the Federal Reserve is now the only major central bank on a clear and certain path toward higher interest rates.

The U.S. is also the only economy among its industrialized peers that is both expanding rapidly and now generating around 2 percent inflation.

Not so for the euro zone, where a spurt of very strong economic activity in the second half of last year appears to be stabilizing in a lower gear, with inflation moving not toward the European Central Bank’s target, but further away from it.

With its key interest rates on the floor, the ECB is still buying tens of billions of bonds a month in economic stimulus and its first rate rise won’t likely come until well into 2019.

The Bank of England now looks set to hold interest rates steady at 0.50 percent on May 10, a massive about-face from a position it had been drumming into financial markets until very recently – that it was likely going to raise them.

While Britain has its own challenges in how to minimize the economic strain from its decision to leave the European Union, the overall change in tune from the BoE, which also targets inflation at 2 percent, is striking.

It is a widely-held view outside the BoE that Britain’s recent bout of inflation was mainly a result of a rise in import prices after the sharp fall in sterling following the June 2016 referendum to leave the EU.

Before the BoE raised interest rates for the first time in this cycle in November, a strong majority of economists called that out as likely policy error.

For open economies – and that list of course still includes Britain – inflation pressure overall is primarily driven by global forces, not domestic ones.

It is also unusual for any one major central bank in a group of closely interconnected economies – through everything from shared consumer behavior to supply chains – to be the only one setting a certain kind of policy for an extended period.

That is one reason why it is concerning to many that the United States still appears to be leaping ahead with the Fed on a solid path to higher rates while many other economies are stumbling.

The latest Reuters polls of more than 500 economists around the globe suggest optimism remains, but the possibility of a U.S.-China trade war threatens to dampen the momentum now in place after years of staggering amounts of stimulus.

The latest signs of a slowdown in business activity in Europe and elsewhere are not worth worrying about yet, according to BNP Paribas (PA:) chief market economist Paul Mortimer-Lee.

He is more concerned about the age of the current U.S. economic cycle, and the threat that next year, synchronized growth in the world economy turns into “synchronized slowdown”.

“All this, together with recent market signals, reinforce our long-standing, high-conviction and out-of-consensus call that 2019 will see a significant slowdown, led by the U.S.,” notes Mortimer-Lee.

“The risk is that supply shortages could bring this forward, and also give a bigger boost to inflation. But we should not get too carried away with recent data, which have several characteristics of a current soft patch, not a bog.”

Source: Investing.com