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Role Reversal: Now Europe Looks Stable and the US Volatile – Bloomberg

For a decade, Americans have looked across the Atlantic with anxiety, fearing that the rolling crises of the euro zone would wreck the world economy. The roles have suddenly reversed. Europe has bounced back and is looking more confidently at its future — with a wary eye to the west, as many assume the biggest threat to the European recovery could well come from America.

The short-term peril facing Europe is already visible in the financial markets. Investors are losing confidence in the ability of U.S. President Donald Trump to deliver on his promise of tax cuts. In the absence of looser fiscal policy and with inflation still subdued, the Federal Reserve could well turn cautious about the prospect of a new rate increase this year. The dollar, which had appreciated steeply after Trump’s election, is now in free fall, and on Tuesday pushed the euro above $1.20 for the first time since early 2015, before paring back some of its losses. The risk that a strong single currency will make European companies less competitive abroad is already weighing on stocks and may soon hamper growth.

A stronger euro could also make it harder for the European Central Bank to end its program of buying government and corporate bonds to sustain the recovery. Frederik Ducrozet, an economist at Pictet Wealth Management, has calculated that the 5 percent appreciation of the euro against a basket of currencies between June and August will force the central bank to cut its inflation forecasts for 2018 from 1.3 percent to 1.1 percent. Of course, stronger domestic growth would have an offsetting effect, which may leave the ECB’s plans unchanged, but even this may not be enough were the euro to rise further.

In theory, none of this ought to be a problem for a central bank: It could just extend quantitative easing, continuing to buy the same quantity of bonds and providing further stimulus as it seeks to hit its inflation target. However, the European Central Bank will soon hit its own self-imposed limits on how many bonds it can buy from some sovereigns such as Germany. While policy makers can in theory decide to circumvent these constraints, for example purchasing more Italian and French debt, such a move would be hard to sustain politically. There is a risk that the ECB will decide to taper the quantitative easing program prematurely, tightening financial conditions while inflation is still short of the target.

A weaker dollar is not the only immediate threat that the U.S. poses for Europe. Another is widespread financial instability linked, for example, to the tensions in the Korean peninsula or to the risk of a prolonged fight over the debt ceiling. While none of these problems are solely Trump’s fault, the president’s ineffectiveness will weigh on investors’ minds. Europe could end up in the middle of a market storm just as its own economic outlook has rarely looked sunnier.

Role Reversal: Now Europe Looks Stable and the US Volatile – Bloomberg

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