Financial markets have been surging the past two weeks, anticipating the potential for more stimulative economic policy after the spate of recent anti-establishment political surprises. Central bankers on both side of the Atlantic, while more restrained, also are preparing for measures that might produce both higher growth and faster inflation.
Following his election as U.S. president, Donald Trump and his advisers have confirmed plans to move quickly on the pro-growth elements of his program, including higher infrastructure spending, deregulation and tax reform. At the same time, he has downplayed the anti-trade components, limiting his remarks so far to U.S. disengagement from the yet-to-be-ratified Trans-Pacific Partnership rather than slapping on tariffs and dismantling existing arrangements such as the North American Free Trade Act.
The Trump example is likely to be followed today by the U.K. In the annual autumn statement, Philip Hammond, chancellor of the exchequer, is expected to outline a grand bargain between the new government and business aimed at promoting growth. It too would emphasize infrastructure spending, deregulation and tax reform.
Both these policy initiatives are a direct result of, and a reaction to, the populist wave roiling much of the Western world. It has already delivered surprise election victories for Brexit -- the U.K.'s June referendum on leaving the European Union -- and President-electTrump; and in both cases, the governing executive party commands a legislative majority. Similar forces may play a role in Italy’s pending referendum on constitutional reforms, as well as next year’s French and German elections -- just to name a few. And ahead of all this, Germany has already hinted at a willingness to support less fiscal restraint in Europe.
This is challenging the long-held perception of an establishment stuck in political gridlock. One result of this paralysis has been the lack of a comprehensive policy response to economic weakness, while placing way too much of the burden for too long on central banks. As a consequence, markets have rushed to price in the prospects for faster nominal gross domestic product growth, taking all three major U.S. stock markets to record highs. At the same time, interest rates have risen throughout the yield curve, increasing the probability that the Federal Reserve will raise rates in December.
Central bankers are also noting the potential change in economic outlook. This will come as a major relief to them, at least for now.
During the past 12 months, a growing chorus of central bankers has spoken out against the only-game-in-town syndrome -- that is, a policy stance that relies too much on unconventional monetary policy, and whose potential collateral damage and unintended consequences should be taken more seriously. More and more they have spoken out on the need for pro-growth structural reforms and fiscal stimulus, where there is room.
As such, their welcoming of a more comprehensive policy response is both understandable and warranted. After all, the biggest challenge facing the West is to deliver faster and more inclusive growth, and not just for purposes of economic well-being, but also for institutional, political and social reasons.
Having said that, the caution of central bankers is warranted at this stage -- and not just because that's their natural tendency. Political pronouncements need to be followed by carefully designed policies and sustained implementation. Otherwise, both the U.K. and the U.S. could face the risk of exchanging a prolonged period of slow and inequitable growth for something even more painful -- stagflation.
What will follow in the next few weeks is crucial, not only for central banks, but also to validate the recent market exuberance. The incoming Trump administration and the U.K. government of Theresa May need to deliver a specific set of measures that promotes nominal gross domestic product, both actual and potential, through greater emphasis on growth relative to inflation. It’s a tricky policy maneuver, after a decade of inaction due to political polarization, and after the prolonged overreliance on private and then central-bank financing as the fuel for growth.
Mohamed El-Erian is the chief economic adviser at Allianz SE.
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