We approach the new year with confidence that the world’s leading economies will continue to display strength and resilience. The US economy is likely to lead from the front, aided by a gathering upturn in the Eurozone and the start of a renewed upswing in global trade. The likely expansion among developed economies should also have a positive impact on the export-oriented, manufacturing economies of East Asia as well as commodity producers in other emerging nations.
United states
A strong labour market (the unemployment rate fell to 4.2% in September — a 16-year low) and benign inflation are likely to underpin moderate real GDP growth in 2018. I expect the US economy to expand by 2.2% in real terms in 2018.
For most of 2017, inflation has undershot the US Federal Reserve’s (Fed) target. Fed governors and presidents have attributed this to one-off reductions in cellular phone contract prices and other exceptional events, asserting that the underperformance of inflation relative to the 2% target is “transitory.” However, after several months of price weakness, the claim that these price changes are temporary is starting to lose credibility. A key moment will come in the spring of 2018, when 2017’s price declines will fall out of the year-on-year comparison. My view is that the underlying problem is slow growth of money and credit. However, I expect no great harm to come from this modest degree of price weakness provided that core inflation starts to pick up again in 2018.
Against this backdrop, the Fed has continued with its policy of gradually normalising — not tightening — interest rates, and in September 2017 the central bank announced the start of a plan to shrink its balance sheet following the scheme announced in June. The “dot plot” released with the Federal Open Market Committee statement suggested another possible interest rate hike in December 2017 plus three further hikes of 0.25% in 2018. This would take the federal funds rate to a range of 2.0% to 2.25% by the end of 2018.
The plan to shrink the Fed’s balance sheet is intended to gain momentum in 2018. Initially, the runoff will start at $10 billion per month during the fourth quarter of 2017, but is envisaged to rise to $50 billion per month in the final quarter of 2018. This means that private sector investors will need to replace the Fed as a holder of these securities, and therefore the US Treasury and government agencies will need to increase auction sizes accordingly. Selling an additional $50 billion of debt securities per month risks raising long-term interest rates, tightening financial conditions, and squeezing bank credit and money growth. In my view, the Fed will need to proceed with caution.
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