COMMENT: Three surprises in 2017

The world could be caught off guard by these potentially transformative developments

Economic pundits traditionally offer their (traditionally inaccurate) New Year predictions at the beginning of January. But global conditions this year are anything but traditional, so it seemed appropriate to wait until US President Donald Trump settled into the White House to weigh in on some of the main surprises that might shake up the world economy and financial markets on his watch. Judging by current market movements and conditions, the world could be caught off guard by three potentially transformative developments.

For starters, Trump’s economic policies are likely to produce much higher US interest rates and inflation than financial markets expect. Trump’s election has almost certainly ended the 35-year trend of disinflation and declining rates that began in 1981, and that has been the dominant influence on economic conditions and asset prices worldwide. But investors and policymakers don’t believe it yet. The US Federal Reserve Board’s published forecasts suggest only three quarter-point rate hikes this year, and futures markets have priced in just two such moves.

As Trump launches his policies, however, the Fed is likely to tighten its monetary policy more than it had planned before the inauguration, not less, as the markets still expect. More important, as Trump’s policies boost both real economic activity and inflation, long-term interest rates, which influence the world economy more than the overnight rates set by central banks, are likely to rise steeply.

The rationale for this scenario is straightforward. Trump’s tax and spending plans will sharply reverse the budget consolidation enforced by Congress on Barack Obama’s administration, and household borrowing will expand dramatically if Trump fulfills his promise to reverse the bank regulations imposed after the 2008 financial crisis. As all this extra stimulus fuels an economy already nearing full employment, inflation seems bound to accelerate, with protectionist trade tariffs and a possible “border tax” raising prices even more for imported goods.

The only uncertainty is how monetary policy will respond to this “Trumpflation.” But, whether the Fed tries to counteract it by raising interest rates more aggressively than its current forecasts imply, or decides to move cautiously; keeping short-term interest rates well behind the rising curve of price growth, bond investors will suffer. As a result, yields on ten-year US bonds could jump from 2.5% to 3.5% or more in the year ahead – and ultimately much higher.