Cheery Fed chairman should be more concerned than he is

One has to be struck by how sanguine the Federal Reserve remains about the risks currently facing the U.S. economy.

This week, in a speech in Portugal, Federal Reserve Chairman Jerome Powell stuck to the Fed’s mantra that the risks to the U.S. economy are balanced and that U.S. financial vulnerabilities remain moderate. He did so despite clearly gathering storm clouds in the global economy.

In assessing risks to the U.S. economy, one would have thought that Powell would be asking two questions: How much damage to the U.S. economy would occur if any of the external risks presently facing the U.S. economy were to materialize? How large was the probability that those risks would indeed materialize?

{mosads}Had Powell asked those two questions, he might not have remained as sanguine as he appears to be. Instead, he might have focused on the following three external risks, which have a good chance of materializing and which would do major damage to the global and U.S. economies if they did.

The first is the deteriorating economic and political situation in Italy, the eurozone’s third-largest economy and the world’s third-largest sovereign debt market.

With the formation of an unstable populist government in Rome last month, whose policy agenda places it on a clear collision course with its European partners, one would have thought that the chances of a full-blown Italian economic crisis within the next six months had risen appreciably.

This is particularly the case considering that the new Italian government is highly unlikely to adopt policies that might place the Italian economy on a faster growth path that might allow it to address its serious public debt and  banking sector problems.

It would also seem to be the case at a time that the European Central Bank is winding down its government bond-buying program as the overall European economy is showing clear signs of slowing, and there is not a negligible risk that Italy’s current government might collapse.

It would be an understatement to say that an Italian economic unraveling would constitute a seismic shock to the U.S. and global economies. It is difficult to see how the euro would survive in its present form were Italy forced to exit that arrangement.

It is also difficult to imagine that an Italian default on its $2.5 trillion dollar public debt would not set off a full blown European banking crisis. That in turn would be bound to send shock waves throughout the global economy.  

The second major external risk that Powell seems to be downplaying is the risk that we could be headed for a full-scale trade war. This is all the more surprising considering how rapidly the Trump administration is ratcheting up import tariffs on China and how difficult it will be for China to accede to U.S. demands without losing face.

It is also surprising considering the latest U.S. threats to increase import tariffs on German automobiles and the dimming prospects of a successful conclusion of the North American Free Trade Agreement (NAFTA) negotiations.

Anyone doubting how damaging a return to beggar-thy-neighbor policies to investor confidence could be need only recall our unfortunate experience with the Smoot-Hawley Act in the 1930s. They might also take a look at how seriously global financial markets have been roiled over the past week in direct response to the heightening risk of a global trade war.

The third risk to the global economy that Powell seems to overlook is the prospect of an abrupt slowing in the Chinese economy as well as those of the rest of the emerging market economies as they struggle with a less open global economy and with U.S. monetary policy normalization.

This is all the more surprising considering that according to the International Monetary Fund (IMF), the emerging market economies now constitute more than half of the global economy, and their debt levels are higher than they were on the eve of the 2008 Lehman bankruptcy.

It is also surprising considering that the currencies of all-too-many emerging market economies are now swooning as capital flows dry up in response to higher U.S. interest rates.

To be sure, in setting U.S. monetary policy, Powell should be focused on attaining the Fed’s dual mandate of high employment and low inflation.

However, by choosing to downplay external risks that could throw the U.S. economy off course if they were to materialize, he reduces the chances of the Fed delivering on its domestic mandate.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.