Paul Carrel Davos

A combination of record low interest rates, ample liquidity and faster economic growth should sustain the world’s recovery from financial crisis this year.

Confident that the outlook for the world’s biggest economy is brightening, the US Federal Reserve has paved the way for an end to its stimulus programme and, after a bout of market turmoil last year, investors seem prepared for this.

But the us central bank’s effort to return to pre-crisis policy settings still represents a huge leap in the dark as it exits from an unprecedented bout of money printing.

An ill-judged move could threaten economic revival worldwide, just one of the dilemmas facing policymakers from America, Europe and Asia as they gather this week for an annual meeting in the Swiss resort of Davos.

Protagonists include us Finance Minister Jack Lew, Japanese Prime Minister Shinzo Abe, European Commission president José Manuel Barroso and central bankers Mark Carney, Mario Draghi and Haruhiko Kuroda. A “senior leader” from China is expected.

Broadly, the risks they face are slower-than-expected us growth, euro zone deflation, an absence of structural reforms in Japan, and bad loans in China.

“While the Fed is trying to normalise monetary conditions to avoid a credit bubble, China is trying to implement financial sector reforms to end one,” Deutsche Bank economist Michael Spencer said. “Both potentially threaten the sustainability of growth.”

The balance of risks for this year may be tilted towards the US and the euro zone, even if policy challenges facing Japan and China appear greater.

Investors have priced in a lot of good news, with European shares hitting a five-and-a-half-year high last week. The risk is that weaker-than-expected growth could knock markets and unsettle the global recovery.

“What could trigger a correction is that growth turns out to be weaker than markets have discounted,” said Andrew Bosomworth, a senior portfolio manager at Pimco. “In the case of equities, markets have discounted some rosy economic conditions.”

The challenge for policymakers in the US and Europe is to manage policy expectations at a time when inflation is not performing as expected.

Some Fed officials worry tepid price rises mean the us recovery is not as solid as it seems. With growth and job creation should come inflation.

Given that uncertainty, us central bankers must convince hesitant consumers that even if the era of quantitative easing is drawing to a close, an interest rate rise remains a long way off.

“The Fed’s next challenge is not over tapering, it is over rates and guidance,” said SGH Macro Advisors chief executive Sassan Ghahramani.

If it fails to convince, market interest rates which often set the cost of borrowing could rise too quickly and choke off recovery in the US and beyond. If that happens, investment will leach out of emerging markets as higher returns lure US funds home.

If low inflation is a puzzle in the US, prices could start falling in Europe. International Monetary Fund managing director Christine Lagarde, who speaks at Davos tomorrow, expressed concern last week. “If inflation is the genie, then deflation is the ogre that must be fought decisively.”

Draghi, the European Central Bank (ECB) president who was feted at Davos last year as the euro zone’s saviour, draws a distinction between deflation as a protracted fall in prices, and necessary internal price adjustments in some countries allowing them to become more competitive.

Bosomworth noted: “The risk is that the internal devaluations that need to be done in these countries morph into deflation.”

Draghi is talking up the ECB’s readiness but shows little appetite to start on a round of Fed-style quantitative easing to stimulate the economy.

Meanwhile, the deflation threat stalks the bloc. Euro zone inflation is running at 0.8 percent, well below the ECB’s target of under 2 percent; it is almost minus 2 percent in Greece, and 0.7 percent in Italy. If Rome gets serious about tackling its debts, inflation and growth could evaporate and make paying down that debt even harder. – Reuters