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The massive infusion of fiscal and monetary stimulus in 2008 and 2009 triggered one of the biggest and fastest global asset-market rallies ever.
Which should make investors nervous. Because both fiscal and monetary policy will start to be withdrawn everywhere this year.
The European Central Bank has all but confirmed that it will start to hike rates next month in response to rising inflationary pressure in Germany and other core European countries. At the same time, countries across the single-currency region are due to be tightening fiscal policy"”that is those that aren’t already pursuing EU-imposed austerity programs.
In the U.K., the government’s long-trailed austerity program really starts to kick in this year. Meanwhile, the Bank of England is under growing pressure to respond to persistently strong inflation.
Across the Atlantic, the Federal Reserve’s second round of quantitative easing comes to an end in June and Fed members are already talking publicly about planning for withdrawal of the extraordinary degrees of accommodation.
And in Congress, the Republicans are pushing for $61 billion worth of spending cuts. This probably won’t go through, but trimming the country’s enormous fiscal deficit is clearly on the agenda.
Emerging markets have been struggling with food and commodity-driven inflation.
China has used its bank reserve requirements to put a brake on rampant lending.
The only country pursuing exceptionally loose fiscal and monetary stimulus is Japan. And its reasons are obvious.
Investors now have to decide on the degree to which exceptionally low interest rates and government willingness to deficit spend were responsible for asset-price appreciation.
There are two schools of thought here. One is that stimulus worked on asset prices by pushing up prospects for economic growth. With the global economy on a sustainable expansionary course, most market gains should be secure even with the slow withdrawal of the scaffolding.
The other school of thought is that zero interest rates also pushed down the yields on other risk assets towards zero. In other words, this was the reason for the dramatic asset-price appreciation. But there was little overall leakage from strong asset prices into overall economic growth. In other words, asset prices were falsely inflated and their true valuations will appear as official interest rates start to normalize or the true trend rates of unstimulated growth are made apparent.
In that case, a removal of the fiscal and monetary props will cause asset-price deflation. If commodity prices fall fast, outright deflation will start to make an appearance as well.
I happen to think the latter is more likely than the former.
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The Source is WSJ.com Europe’s home for rapid-fire analysis of the day’s big business and finance stories. It is edited by Lauren Mills, based in London.
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