Recent developments in financial markets have tested certain constants, only to find them changed, and beliefs, only to find them altered. It used to be that the price of gold would rise in times of conflict and war, but now it falls. To find the explanation, look at interest rates. War means higher energy and other commodity prices, prompting the Federal Reserve to raise interest rates to curb inflation, which strengthens the dollar and increases demand for it; gold offers no yield to its holder, unlike the dollar. Moreover, gold is priced globally in dollars, so a stronger dollar increases the cost of gold, reducing demand. Demand for gold is driven by fears accompanying the onset of wars and crises; when fears dissipate, demand naturally declines. Also, in times of tension, demand for liquidity from creditors rises, and gold held is easier to liquidate into cash, increasing its supply and lowering its price. Central banks in times of crisis may defend their local currency against the dollar by selling part of their international gold reserves, increasing supply and lowering its price.
It was conventionally understood that financial markets would fall when reports indicated declining employment and rising unemployment, but now they rise. Again, look to interest rates for the reason. Since the global financial crisis in 2008, financial markets have become dependent on cheap financing. We know that if the employment situation worsens and specters of recession appear, the Federal Reserve lowers interest rates, increasing liquidity and raising demand for securities. Moreover, many popular securities do not depend on labor demand as much as they depend on capital intensity, as is the case with the technology companies dominating the markets.
British economist Jim O'Neill points out that the US financial market is currently valued at about $77 trillion, half the value of global financial markets, yet the US economy's share is no more than a quarter of the global economy, whose center of gravity is shifting eastward, to China, India, and their neighbors. The critical question, whose answer depends on market and real economy developments, is: Will the US economy surge to high growth, as optimists predict, thanks to increased efficiency and productivity linked to artificial intelligence, whose companies are seeing offerings in markets and rising valuations? Or will the market experience waves of correction and decline, bringing it closer to the reality of the real economy? O'Neill recalls that the Japanese financial market experienced a violent correction when its market capitalization was 45% of the global financial market in the early 1990s, then suffered a decline over three and a half decades.
This week marks the first meeting to set interest rates for the Federal Reserve under its new chairman, Kevin Warsh, whom the markets are closely watching. While financial markets currently expect neither a raise nor a cut in interest rates, the credibility and independence of the new chairman are subjects of anticipation and testing regarding his inclinations. His predecessor, Jerome Powell, faced continuous criticism from US President Donald Trump for refusing to lower interest rates. Warsh comes with impressions that his loyalty to Trump may lead him to prioritize responding to current political and economic pressures over market stability and controlling inflation in the longer term. Notably, the Federal Reserve is distinguished from other central banks in that it is mandated by Congress to pursue maximum employment, i.e., reducing unemployment, in addition to the usual task of monetary authorities in maintaining monetary stability by lowering inflation rates. Besides this dual mandate, it is also responsible for financial stability through oversight of banks and their solvency.
The Federal Reserve faces a rising inflation rate, reaching 4.2% in May, the highest in three years or more, more than double the stated target of 2%. The inflation rate in February was 2.4%, then prices continued to rise rapidly, coinciding with what is known in the United States as the effect of the war with Iran. The current situation does not necessarily justify lowering interest rates, contrary to the US president's desire, especially with improving unemployment indicators according to the latest labor market report; therefore, the majority vote will likely favor holding steady. Warsh's vote with the majority would reinforce the signal of his executive independence from Trump, and also give him an opportunity in the press conference to explain the developments shown by inflation and unemployment report data. Although he has rightly criticized the excessive reliance of interest rate decisions on data that does not reflect current economic developments. The aforementioned reports may reflect what happened, not what is actually happening or expected to happen; this has led to criticism that the Fed's decisions have been slow in dealing with inflation, and that it mistakenly perceived inflation waves as transitory, contrary to their nature, and thus did not take action, causing these waves to persist longer.
Meanwhile, the latest report on global economic prospects, issued days ago by the World Bank, shows indicators of a sharp decline in global growth rates to 2.5%, the lowest since the COVID-19 pandemic, with expected growth for developing countries and emerging markets falling to 3.6%. This threatens employment opportunities and complicates prospects for achieving development goals in these countries, which are expected to receive 1.2 billion job seekers over the next decade. These matters, despite their importance, are not decisive for the Federal Reserve's decision, nor are they of concern to financial markets amid their upward surges, even temporarily.
