We got a taste of what that means earlier this year with the failure of several regional banks in the United States. The Federal Reserve bailed out banks and the market briefly calmed down.
U.S. bond yields have recently surged more than a percentage point as government borrowing increases and the Federal Reserve reverses previous quantitative easing to increase bond supply. This reflects the market's recognition that short-term interest rates need to remain high for an extended period of time to reduce inflation.
As a result of contradictions in the US budget and monetary policy, the US economy has not slowed down as rapidly as expected, despite rising short-term interest rates. The labor market remains strong.
Hoping for a middle path
What happens next? Biden has no intention of changing US budget policy anytime soon, so unlike the UK, the US will stick to accommodative US budget policy for some time. Congressional conflict further increases the risk.
Federal Reserve Chairman Jerome Powell may continue to raise short-term interest rates to slow the economy and perhaps end quantitative tightening to take some pressure off the bond market. The likely result is an unexpected collapse of financial and commercial real estate markets, which is unlikely to subside smoothly this time.
At the other extreme, Mr. Powell could halt rate hikes and accept that inflation will remain high for an extended period of time. If that happens, there is a risk that bond yields will rise further due to inflation concerns, which could still trigger an unexpected collapse in financial markets.
Despite the contradictions between monetary and budgetary policy, is there a middle path for Powell to gradually reduce inflation without blowing up financial markets? We all hope so, but it's not certain. Unlike the UK, what happens in the US will have a huge impact on the global economy. If the United States has a hard landing, other countries will have a hard landing as well.
Where is Australia going?
As previously discussed, most countries have short-term interest rates above long-term interest rates in order to slow the economy. Short-term interest rates are lower than long-term interest rates, and monetary policy has not been tightened much. There is growing evidence that inflation in the region will remain too high as wages rise and gas, rent, insurance and home prices rise. Drought and climate change policies could make matters worse.
The justifications given for our weak monetary policy settings are baseless.
The mid-2024 tax cut will offset a further shift by some borrowers from lower fixed rates to higher variable rates.
Wages here have grown by nearly 4%, slightly lower than in other regions. However, our productivity has declined significantly over the past year compared to other regions. Unit labor costs are rising rapidly, which will constrain service inflation.
Domestic policy should be cautious until it becomes clearer what will happen to the U.S. economy.
While most other countries have suffered from rising import prices, we have benefited from rising export prices. Other countries have budget surpluses rather than deficits, but this reflects increased incomes and does not justify very low short-term interest rates here.
Considering the risks posed by the United States, it will be difficult to chart the right policy course through the turmoil that may ensue. The attack on Israel by Hamas and its potential impact on the oil market also points to the risk of new shocks.
Until it becomes clearer what the future holds for the U.S. and global economy, we should be cautious about domestic policy.
We cannot afford to put our policies on hold. Otherwise, higher foreign interest rates would depreciate the exchange rate and push up inflation. Monetary policy needs to be tightened further in order to continue to reduce inflation and increase economic flexibility, rather than to reduce inflation as the government's labor market policies do.
Although we have weathered recent global shocks and have fared better than most companies, there is no guarantee that we will continue to do so. The priority is to control inflation and increase productivity. Our strong banking sector at least gives us some protection from financial market shocks.
Reserve Bank of Australia Governor Michelle Bullock could face major challenges from the global economy that could complicate a smooth landing here. Government policies must support her, not make her job more difficult.
Ed Shan is an independent economist.