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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Why do global markets take such an emollient view of the economic consequences of Donald Trump? This week he re-escalated the conflict around the world’s most critical chokepoint in the Strait of Hormuz, highlighting his ability to make the global economy more vulnerable to supply shocks and potential stagflation. The inescapable conclusion is that the prospects for a durable US-Iran peace are now depressingly remote.
Trump’s tariff wars and weaponisation of trade and finance continue to promote the unravelling of the immense economic efficiencies wrought by globalisation. His erratic approach to policymaking raises uncertainty to an unprecedented level. And the damage resulting from Trump’s unwinding of the collaborative postwar order is incalculable.
A Trump apologist would no doubt argue that the economic damage the US president has done has been greatly exaggerated. The IMF is, after all, projecting global growth of 3.0 per cent in 2026 and 3.4 per cent in 2027. Not bad in the light of what IMF economists call the largest disruption to the oil market in decades.
As for higher trade barriers, the costs were lessened by effective tariff rates that turned out to be lower than initially anticipated; also by trade diversion and firms’ willingness to absorb costs through lower margins. It could be argued, too, that the strategic challenge posed to the US by the rise of China made the weaponisation of trade a priority over the pursuit of economic growth.
Meantime, the AI investment boom in the US has created market euphoria, bearing comparison with the canal mania of the 1830s, the British railway mania in the 1840s, the electrification exuberance of the late 1920s and the dotcom boom of the late 1990s. It serves as a reminder of the extraordinary capacity of the US corporate sector to get on with business regardless of the theatrics that emanate from Washington.
Yet all this takes place against the background of unusually loose monetary and fiscal policy. The Federal Reserve has not met its inflation target for years and the budget deficit is running, incredibly, at about 6 per cent of GDP. Public debt is at levels not seen since the end of the second world war. The US economy is, if you will excuse the vernacular, being run unbelievably hot. There is zero prospect of desperately needed debt consolidation in the foreseeable future. This, of course, is not an exclusively American phenomenon.
A price will have to be paid for all this. As the Bank for International Settlements points out in its annual economic report, those historic market manias shared a common trait: a genuine technological breakthrough that attracted capital in excess of what commercial returns could ultimately justify. They ended with an eventual reversal in investment, inducing economy-wide recessions. The BIS suggests that the scale and pace of the current AI investment boom bear resemblance to these precedents.
There are signs, notably in the bond market, of an incipient Trump discount. Since the Covid pandemic, long-term Treasury rates have been creeping inexorably upwards. Yet today’s higher yields do not take the full measure of the potential inflationary risks.
The failure of the advanced countries’ central banks to anticipate the inflationary surge of 2022-2023 has, in the jargon, de-anchored inflationary expectations. After years of positive supply shocks resulting from favourable demographics and globalisation, the world now faces a reversal: huge requirements for age-related public spending, increased defence needs and rising costs relating to climate change.
At the same time the Fed, along with other developed world central banks, is on a very difficult hook. In recent years, the financing of public debt has been heavily biased towards short-term IOUs. This shortening of duration means that raising policy interest rates in response to rising inflation inflicts instant increases in debt-servicing costs on governments.
There is thus a risk of inflationary debt monetisation whereby governments require the central banks to finance their deficits — so-called fiscal dominance. And then there is the problem of financial dominance. A growing proportion of short-term public debt is held by fickle, highly leveraged hedge funds. It follows that any move by central banks to tighten monetary policy can be financially destabilising. That implies that central banks will repeatedly find themselves under pressure to bail out banks and quite probably non-banks when instability strikes.
With US monetary and fiscal policy at full tilt, and with financial conditions conspicuously easy, it is too soon to predict a market seizure. Yet we are left with potentially endless hostilities in the Gulf following a war that has totally failed to bring about regime change in Iran. The Trump administration increasingly resembles Plato’s ship of fools. The patience of the bond markets will ultimately wear thin. My guess is that the crunch will come within the next twelve months.
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