Economists sometimes talk about concepts like fiscal dominance and monetary dominance, under which certain macroeconomic characteristics tend to dominate policy making. Sometimes there is also talk of financial dominance, in which policy is constrained by considerations for financial stability. But after attending the annual meetings of International Monetary Fund and the World Bank in Washington DC over the last few days, my overwhelming takeaway is one of US dominance. The US society may have internal chasms, and some of its political institutions and processes may have weakened in recent years, but as far as the rest of the world is concerned, US monetary and financial market policy, US demand, US industrial policy, and US sanctions loom above just about all other considerations.

US

Inflation remains the dominant issue, from election advertisements to talk shows, it’s mostly about inflation. Recession may be looming, housing may be on the cusp of slowing, hiring freeze may be making way for job cuts, but those are emerging risks, whereas inflation has taken hold of the society’s psyche. There is hardly any mention that core goods price inflation is zero on a month-on-month basis; instead, the concern is that the services side prices are showing signs of acceleration. Latest price data show that elevated food prices are affecting sentiments, whereas rents remain high, and energy prices, ranging from heating oil to electricity to gasoline, are at uncomfortable levels, with emerging upsides going into winter. Wages, pension indexation, cost of living adjustment allowances, these are all playing catch up with rising prices. This means that the much-feared wage-price spiral is already here to some extent.

These price developments are taking place at a time when the income and savings of Americans are robust, neither housing nor the job market are showing any meaningful cracks yet, and the monetary and fiscal tightening put in place so far have not subtracted from economic activity substantially. The implications are clear: the Fed will keep hiking through November and December, and perhaps even into the new year.

The sharp rise in US rates have caused the USD to strengthen by nearly 20% this year, and there were some talks during the course of the IMF meetings that this is a wrecking ball for the global economy, causing corporate and sovereign distress worldwide, which, in turn, could hurt the bottom line of US corporations with large foreign operations. Ideas like the need for coordinated intervention by major central banks were floated, but it seems clear that the US government has no desire to do anything in this regard. Strong dollar tends to be negatively correlated with commodity prices, which is a useful channel to import disinflation. Besides, buying foreign currency by injecting dollar liquidity is not considered consistent with the Fed’s battle against inflation. Bottom-line, don’t expect the Fed to help out on currency matters any time soon.

The US policy makers are providing an array of messages to their counterparts—be prepared to deal with tighter dollar liquidity, more restrictions on doing business with China, more support for building in the US, and more industrial policy aimed at supporting US firms. This is an inward looking, competition averse, resiliency focused America, and there is virtually no difference between Democrats and Republicans on these matters.

For firms and governments in Asia, navigating trade and commerce and foreign policy with such an assertive US will be challenging, to say the least.

Financial stability

Moving on from the US, one concern heard during the meetings, predictably, was financial stability risks in the midst of rising Interest rates and an ascendant dollar. The fact that US policy makers are not putting much weight on this matter for now does not make this issue go away. Indeed, recent turmoil in the UK gilts market was an illustration of risks that may be lurking on public or private balance sheets.

It’s an important question. After the end of the era of low-for-long, which accidents await the global economy in the rates normalisation phase? Is the stress faced by UK pension funds a canary in the proverbial coal mine for financial markets?

One stress point during the 2008 crisis was when financial institutions saw their leveraged positions on securities with low historical volatility experience simultaneous rise in volatility and evaporating liquidity. This caused a spiral of forced selling and deeper losses. The key question is if something like that is brewing presently.

Interest rates have been exceptionally low for over a decade, during which period asset managers around the world have gone up the risk spectrum in their quest for yield. Many have also taken on substantial leverage to boost those yields. It should hardly be surprising if some of them are now facing growing capital losses as rates rise and liquidity tightens. Could a redux of 2008 be in the horizon, in which one sees mark to market losses forcing margin calls, leading to forced selling, and further decline on bond prices? Could such dynamic precipitate financial instability? I fear that we may not have to wait too long to find out.

Ukraine and Europe

Moving on from financial stability, the war in Ukraine and the impending recession in Europe were widely discussed. The US is leading the military aid efforts, and drawing in partners to support substantial economic aid; the latter has faced some administrative and program design hurdles. Still, the resolve of Western nations on the war looks formidable.

Of course, the energy supply shock emanating from the war is going cause a recession in the Eurozone, the only question is how severe. Some estimates show that the shock facing Europe from high heating and power prices is bigger than what hit the US during the 70s oil crisis. The fact that ECB is hiking interest rates going into this war driven recession is absolutely extraordinary. Fiscal and financial levers are moving in almost the opposite direction of monetary tightening in Europe, underscoring the difficulty posed by the current situation.

EM

What about emerging markets? Will they be a casualty of the shocks coming from the US and Europe? Typically, the answer is yes, but during these meetings, it was clear from body language of the major emerging market economies’ policy makers that they don’t feel that helpless. Nations like India, Mexico, and Vietnam are benefiting from the China plus one strategy, commodity exporters like Brazil and Indonesia are enjoying favourable terms of trade, and many are in the early phase of post pandemic economic reopening. Also, reserves have been built and debt burdens appear manageable.

Now, this is only one part of the picture. Beyond the large emerging market economies, there is considerable stress. Debt crises have popped up in South Asia, Latin America, and many parts of Africa. These countries have difficult restructuring ahead, and many would need adjustment programs with multilateral lenders. One problem is dealing with China’s debt to these countries, which the Americans are insisting be subject to sizable haircuts.

China has already begun providing debt relief to various borrowers, but the process has run into problems. China’s preferred strategy is to offer longer maturity new loans with lower interest rates, which leaves the face value of the loan unchanged but provides the borrower with a decline in the net present value of the obligation. But typical international debt restructuring entails a write-down of the outstanding principal, something the Chinese authorities are disinclined to undertake. Essentially, these are similar in effect, and should be fine from a multilateral perspective. We hope that developing country debt distress won’t be a casualty of these technical differences in approach.

China

Speaking of China, little confidence was expressed during the meetings about its outlook. Between zero Covid, property market distress, tech regulation, constant pushback by the US, China’s challenges are many. Unlike the aftermath of the global financial virus, when China held up global demand with a massive stimulus program, no one is holding their breath for a repeat this time.

Conclusion

So, overall, a grim gathering of global economic decision makers, with a sense of foreboding about tough times ahead. Higher rates, currency market volatility, developing country debt distress, great power rivalry, war, and risk of financial instability are sources of concern; no wonder that financial markets feel little joy.

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