The Real Threat to the Global Economy

From Wall Street to Russia to Australia, fear of inflation has central bankers nervous, markets tumbling, and growth uncertain

Is something seriously wrong in the global economy? The world's investors seem to think so. On June 13, stock indexes in Japan and Australia had their biggest point losses since the aftermath of the September 11 terror attacks. The Russian Trading System Index dropped nearly 9%. Stocks fell sharply in Turkey and India as well.

In the U.S., the Standard & Poor's 500-stock index fell 12.7 points, to 1223.69, bringing its decline since May 9 to nearly 8%. Stocks that have been hit range from homebuilder DR Horton (DHI) and Wall Street's Lehman Brothers (LEH) to telecom provider Sprint Nextel (S), to Sirius Satellite Radio (SIRI).

In fact, there hasn't been any breaking news about a braking world economy. What changed abruptly are expectations. Investors have suddenly decided that the world economy is in danger from one of two things: inflation, or overzealous efforts by the Federal Reserve and other central banks to combat inflation.


  "If there's one lesson to take away from the last few weeks of market volatility, it's 'Never underestimate how quickly the financial markets can turn,'" Joseph P. Quinlan, chief market strategist of Banc of America Investment Advisors, wrote June 13. He added: "What's trendy today can be toxic tomorrow."

The primary source of the global agitation is the U.S., the world's largest economy. On June 13, the government reported that producer prices, other than fuel and food, rose 0.3% in May. That reinforced fears that the Fed will raise rates at its next meeting June 29.

If high interest rates cause the U.S. to sneeze, the rest of the world catches a cold. World sentiment began to turn negative in early May after the Federal Reserve hiked short-term interest rates to 5% and hinted that another hike might be in store. Higher rates are already chilling the housing market, which is a sensitive leading indicator for the economy. Homeowners who feel poorer could spend less, which would be bad for American companies as well as for America's foreign trading partners.


  The pessimism has intensified over the past week as Fed Chairman Ben Bernanke and other Fed policymakers have made one hawkish statement after another about the need to stop inflation. Investors, accustomed to the subtle formulations of Alan Greenspan, have been rocked by Bernanke's bluntness—"smoke bombs instead of smoke signals," in the words of Standard & Poor's economist Beth Ann Bovino.

The Fed's forthrightness about the perceived need for more tightening may have helped embolden other central bankers. India, Turkey, South Korea, South Africa, and the European Central Bank have all raised their benchmark rates in recent weeks. "I think that the Fed still drives the bus," says David Rosenberg, Merrill Lynch & Co.'s chief North American economist. He also thinks that the Fed risks overdoing the tightening, pointing out that with the latest figure on producer prices, the total increase in 2006 in consumer-related producer prices—stripping out energy—is 0.0%, "goose egg."

Judging from the uniformity of pessimism in the financial markets, it appears that the world's economies are moving in lockstep. But that's not the case. In fact, economic circumstances around the world are radically different. In China, growth is too fast. The problem is overheating caused by an undervalued currency (see BW Online, 06/13/06, "Big Economy, Bigger Peril?") Japan is just gradually emerging from a prolonged slump. Russia has a huge trade surplus because of big oil exports. The U.S. is running an enormous trade deficit.


  So why are markets behaving so similarly? Because all are affected by the global trend in central bank tightening, which dries up the flow of money into stock markets. Even if the Fed does pause in its tightening campaign after getting to 5.25%, the European Central Bank and the Bank of Japan may keep raising, says Merrill's Rosenberg. As long as other central bankers are still tightening, "it's not as if the global investor gets a 'get out of jail free card,'" he says.

If the central bankers strive too hard to prove to prove their inflation-fighting credentials, they could end up overshooting and damaging world economic growth. "We may hit a point where the baby gets thrown out with the bathwater," he says.

Investors are taking all of this in as if they had never imagined bad news before. Until recently, Rosenberg says, "they acted as if risk was a dirty four-letter word" and poured money into high-yielding assets as if nothing could possibly go wrong. Now, the biggest declines are occurring in some of the markets that saw the biggest increases, such as India, Turkey, Brazil, and Russia, says Brad Setser, an economist at Roubini Global Economics in New York. The fact that the biggest gainers are the biggest losers, apart from all other factors, "is the strongest evidence that investor perceptions have changed faster than any fundamental conditions have changed," Setser says.

How much worse could things get? That's impossible to say. Combine volatile investors with unpredictable central bankers, and you have a market that could go way down -- or way up, in a flash.

Before it's here, it's on the Bloomberg Terminal.