Christine Lagarde had good news to tell when she turned up in Davos three weeks ago to announce the International Monetary Fund’s latest economic forecasts. The global economy was doing better than expected pretty much everywhere, the IMF’s managing director said.
There was, though, another message, a warning not to get too carried away about a recovery that had left out large numbers of people and was not based on particularly solid foundations. “There is also significant uncertainty in the year ahead,” Lagarde said. “The long period of low interest rates has led to a buildup of potentially serious financial sector vulnerabilities.”
The IMF does not always get it right but on this occasion Lagarde nailed it. Over the past week, shares on Wall Street have fallen sharply, with the Dow Jones recording 1,000-point-plus declines on two separate days.
Speaking in Dubai on Sunday, in her first public comments since the market turmoil, Lagarde said she remained “reasonably optimistic” but that “we cannot sit back and wait for growth to continue as normal”.
Somewhat perversely, the markets came down for the same reason as they rose steadily throughout 2017: because of the brighter economic news Lagarde reported. The trigger for the sell-off was a US labour market report, which showed more jobs being created, wages going up and unemployment at 4.1%.
Most Americans would struggle to work out why this would cause share prices to plunge. After all, unemployment has been coming down steadily for years, during which time US workers have struggled to make ends meet. Annual earnings growth is still running below 3%.
But from the perspective of Wall Street, these are now seen as unwelcome developments. In 2017, the financial markets bought shares because they thought the US was in for a prolonged period of strong growth, weak inflation and low interest rates.
The moment the jobs report came out it was as though a switch had been flipped. Markets now viewed stronger US growth with trepidation because they thought it would result in higher inflation and tougher action from the US central bank, the Federal Reserve. Donald Trump’s package of tax cuts, finally pushed through Congress at the end of last year, ceased to be the growth-boosting, productivity enhancing benefit to the economy it had been in 2017 and suddenly became a means of overheating the economy and driving up the US budget deficit. Because Washington would need to borrow more to bridge the gap between its spending and its tax revenue, the assumption was that interest rates would need to rise.
As it happens, some of Wall Street’s assumptions are questionable. Take the idea that America is running at full employment, for example, where the 4.1% jobless rate masks the fact that labour market participation has yet to get back to where it was at the start of the Great Recession a decade ago. America’s employment rate is currently just over 60% – 3 percentage points lower than it was in 2008.
