Warnings about risks to the global economy are so common these days that it’s easy to become inured to them, but the few days since the world’s finance chiefs assembled in Washington have seen a series of them materialize in quick succession.

First it was climate change, as Dubai was blasted by a rainstorm of biblical force that exposed the vulnerability of one of the world’s most modern cities. 

In the small hours of Friday, reports of an Israeli counter-strike against Iran dashed hopes that the two Middle Eastern powers would now allow things to settle down again after their first direct exchange of lethal force.

In between them, on Thursday, the risk that lies closest to financiers’ hearts moved a step closer to reality: as one of the Federal Reserve’s policymakers floated the idea that interest rates may have to rise still further to bring inflation under control. 

“[If] inflation starts moving in the opposite direction away from our target, I don’t think we’ll have any other option but to respond to that,” Atlanta Federal Reserve President Raphael Bostic told an event in Florida. “I’d have to be open to raising rates.”

That wasn’t supposed to happen. The International Monetary Fund at its its spring meetings had sketched out a future in which the world economy achieves a "soft landing" as the Fed and the European Central Bank slowly but steadily bring interest rates down from restrictive levels. 

In the short term, at least, the economic consequences of war and climate change might be manageable as long as central banks are able ease off the brakes to give the economy support when needed. But that becomes harder if the U.S., which sets the tone for global financial markets, is having to hike rates ever higher to stop its economy overheating. 

“The latest data out of the U.S. very much urge us to be cautious,” Bundesbank President Joachim Nagel told a briefing on Thursday.  

Higher interest rates would mean a higher dollar, and a higher dollar generally means pain for the world economy. As such, Bostic’s comments were highly unwelcome, the clearest sign yet of how badly a string of hot U.S. price data this year has changed the calculations on bringing inflation to heel. 

Complicating the picture

It certainly complicates the picture for Europe. Seven months after raising its deposit rate to a record-high 4 percent, the ECB has found its way to near-unanimity that it should start cutting rates in June.  

Bank of Portugal Governor Mário Centeno was emphatic on Thursday that the ECB should already be cutting rates, even though inflation remains fractionally above target.

“I wonder why we fret about 0.1 percent,” he told an event on the sidelines of the IMF meetings. “We have already been successful.”

Centeno warned that the labor market miracle, which has seen unemployment fall to an all-time low in the eurozone despite record high interest rates, won’t last forever. "Europe must not destroy its gains in the labor market: firms are not charities,” he warned.

That’s a line that was echoed on Thursday by Germany’s largest unions. 

"The ECB should really have started a turn in the interest rate cycle at its last meeting,” Ver.di’s chief economist Dierk Hirschel told the newspaper Handelsblatt, warning that it would still take months for such support to reach the economy.

Yet the same Ver.di was only last week proudly telling its members that it had secured a pay rise worth up to 18 percent over two years for its members at German airline Lufthansa, a powerful illustration of how wages are ‘catching up’ with past inflation and becoming more of a supportive factor. The expected increase in real incomes is one of the key reasons why the ECB expects the recovery to gain momentum over the next year.

Moreover, cutting rates while the Fed is talking about raising them is likely to push the euro lower, creating the optics of actively trying to steal a competitive advantage against U.S. companies. And that could provoke a reponse of import tariffs from a re-elected Donald Trump, or even from an incumbent president Joe Biden, in an effort not to be outflanked running up to the vote in November.

So what happens after June is anyone’s guess. The ECB expects inflation to be bumpy for the rest of the year, after hitting a two-and-a-half-year low in March. It is acutely sensitive to the optics of cutting rates if headline inflation is not actually falling any longer. 

As BNP Paribas chief economist Marcelo Carvalho told POLITICO on the sidelines of the meetings, growth is resilient, inflation is  sticky, and so policy is likely to stay cautious.  As many have observed in recent weeks, "the last mile is the hardest” when it comes to ending a three-year inflation episode that has upended the lives of millions. 

On the brighter side, Carvalho argued that the eurozone, which has barely grown for the last six quarters, will return to its long-term trend, while the U.S. will not keep up its current pace. That will end the "divergence" between the two blocs that has been the talk of Washington this week. The ECB may still envy the faster growth across the Atlantic, but at least as far as inflation is concerned, Carvalho noted: "The last kilometer is shorter than the last mile.”