Macro View: Higher inflation, political risks are main 2017 threats

The equity markets have welcomed the arrival of 2017 with strong rises, continuing the significant net gains recorded in 2016. But, underneath the mood of optimism, there is also a sense of unease and apprehension. 2016 was a year of economic and political shocks that triggered acute worries, notably the Brexit vote and Donald Trump’s victory. Most gloomy prophecies have proved groundless so far. In spite of the vote to exit the EU, the UK has performed much better than most analysts predicted. More significantly, pre-election fears over Trump have faded, and there are now expectations that US growth will improve as a result of the new president’s policies. Share prices have risen strongly since Trump’s win, and there are widespread hopes that the positive tone in the markets will continue during 2017. There is a strong belief that increased infrastructure spending, which the incoming US administration is planning, would stimulate activity and drive the economy forward. But there are also deep concerns that the current buoyancy may prove temporary, and new shocks may unleash turmoil and setbacks in the coming months. The optimists have dominated the markets in the early days of 2017. But these are early days.

US economic activity

It is widely expected that US economic activity would be stronger in 2017 than in 2016. We are raising our GDP growth forecasts, to 1.6% in 2016 and 2.3% in 2017. The upgrading is partly due to better-than-expected official figures. After prolonged sluggishness, US GDP surged temporarily to an annualised growth of 3.5% in the third quarter of 2016. Even if this rapid pace moderates in the next few quarters, there is a strong belief that the Trump Administration would pursue expansionary policies that would raise the pace of growth. The key issue is whether the stronger growth would be sustainable. The main concern is that US inflation would accelerate markedly and, if this forces the Fed to push up interest rates, the recovery could be aborted. At present, these fears seem exaggerated and there is room for cautious optimism. While some rises in US inflation and interest rates are highly likely in 2017, the increases currently expected would not, on their own, abort the recovery. But there are clear danger signs, and the risks are likely to increase, particularly if the fiscal stimulus administered by the Trump Administration appears excessive.

Inflation and unemployment

Though US inflation is still low by historical standards it is edging up. In November 2016, headline consumer price (CPI) inflation was 1.7%, while core CPI inflation, which strips out food and energy, was 2.1%. Wage pressures are accelerating. Average earnings recorded annul growth of 2.9% in December 2016, a rate of increase noticeably higher than CPI inflation. The labour market is solid. Total nonfarm employment rose by 156,000 in December. In 2016, US job growth totalled 2.2m, less than the 2015 total of 2.7m but still strong expansion. With the unemployment rate at 4.6-4.7% in recent months, a level generally perceived as being near to “full employment, the Fed concluded that the US labour market is sufficiently strong to justify its recent decision to raise its key interest rate by 25 basis points to a new range of 0.50-0.75%. While the Fed’s move – the first hike in 12 months – was very widely expected, it reinforced expectations that the pace of tightening would become more forceful during 2017. The current consensus is that three additional increases are likely during 2017, which would bring the Fed funds rate to 1.25-1.50% at the end of this year. This pace of increase is moderate and is consistent with a benign scenario, which combines higher growth with rising but still tolerable inflation. But the Fed cannot afford to remain complacent, if the bond markets start to convey messages of concern.

Bonds and trade

The long bull market in bonds, which has lasted for more than three decades, has very probably come to an end and yields have risen over the last 6 months. So far, increases in bond yields have been relatively modest, but the situation can change abruptly. If, in reaction to excessive fiscal expansion, bond yields start signalling worries, the Fed may be forced to accelerate the pace of its monetary tightening. 2017 may also heighten new political concerns resulting from the dramatic change in US political leadership. Though initial fears over Trump have subsided, the president-elect is reputed to be unpredictable and there is unease over how key foreign policy issues would be handled by the new administration. While better relations between the US and Russia’s president Putin may be a welcome development, there are serious risks that Trump’s trade policies, driven by his protectionist instincts, may heighten tensions with key players such as China, Mexico and even Canada. Trump may also have uneasy relations with the eurozone. Many European leaders made adverse comments about Trump and this will now make it hard to re-establish a warm and trusting Atlantic Alliance. Within the US, lack of trust between Trump and the Republicans in Congress may create an unstable political relationship.

Banking in the eurozone

Higher inflation and political uncertainties are also emerging as the main 2017 risks in Europe. In the eurozone, the financial background is more stable. Fears of a new crisis have eased, even though there are concerns over the banking sector’s resilience. Eurozone growth prospects have been upgraded and we are now forecasting full-year GDP growth of 1.6% in 2016 and 1.4% in 2017. However, eurozone annual inflation surged to a higher-than-expected 1.1% in December 2016, the highest level in more than three years. This largely reflected a particularly sharp increase in German inflation, which accelerated to 1.7% in December, the highest level since July 2013. Though eurozone inflation is still below the official target of “just under 2%”, and some of the December price surge may be reversed, previous fears of deflation have faded. Germany is particularly sensitive to risks of higher inflation and one can expect renewed pressures on the European Central Bank to consider a gradual exit from its ultra-loose monetary policies. Earlier ECB plans for additional stimulus will probably be abandoned. We may even see some modest tightening by end-2017.

Mounting political tensions

Political tensions are now mounting across Europe. In Italy, prime minister Renzi was forced to resign, after failing to secure support in a referendum for constitutional changes. Populist parties are gaining support, mainly due to fears over high levels of immigration. National elections are due in 2017 in the Netherlands, France and Germany. The campaigns will probably reinforce the growing support for nationalist forces and add to potential instability. In the UK, political uncertainties over Brexit are unsettling the markets, even though the economy is stronger than most analysts predicted after the June referendum. Quarterly GDP growth in the third quarter of 2016 was upgraded from 0.5 to 0.6%. Our full-year UK growth forecasts are being raised slightly, to 2.2% for 2016 and 1.7% for 2017. But UK inflation is edging up. Annual CPI inflation rose from 0.9% in October 2016 to 1.2% in November. It is widely expected that price increases would accelerate this year, with UK CPI inflation likely to exceed the 2% target from the middle of 2017 onwards. The Bank of England will not tighten policy immediately. But, with inflation edging up gradually, I expect modest increases in official interest rates from mid-2017 onwards.

David Kern of Kern Consulting was chief economist at the British Chambers of Commerce between 2002 and 2016. He was group chief economist at NatWest between 1983 and 2000.