The World Trade Organization warns of a divided economy, the Fed faces inflationary pressures, and the Japanese yen is at a crossroads

On Tuesday, the World Trade Organization called on its members to reform global trade rules, warning that failure to do so could push the global economy toward further division and fragmentation, threatening to reduce global economic production and cause serious harm to the poorest countries.

The Geneva-based organization said in its annual report that current trade rules are facing increasing difficulty keeping pace with shifts in the balance of global economic power, the rise of industrial policies, and the expansion of digital trade, as well as escalating political tensions between major powers, according to Reuters.

This warning comes after the failure of the 166 member states of the Organization to reach an agreement on a reform package during the ministerial meeting held in Yaoundé, Cameroon, last March, before the resumption of negotiations in Geneva on issues including decision-making mechanisms, settlement of trade disputes, and challenges related to government support and state intervention in the economy.

The Organization faces difficulties in achieving consensus among all its members. Given the different levels of economic development and the divergence of interests among member states, in light of their reliance on the principle of consensus in decision-making.

Models prepared by economists at the Organization showed that the division of the world into competing geopolitical blocs may lead to a decline in global gross domestic product by 5.1 percent, and a decline in global exports by 18.6 percent, by 2050, compared to the basic path.

In a more extreme scenario, in which multilateral cooperation collapses and is replaced by a scattered network of free trade agreements, global GDP could fall by 6.9 percent and exports would fall by about 27 percent.

On the other hand, the report indicated that strengthening multilateral cooperation could raise global GDP by 2.9 percent and increase global exports by about 18 percent.

The organization stressed that the least developed countries will benefit the most from strengthening international cooperation, but at the same time they will be the most vulnerable to losses if the disintegration of the global trading system accelerates.

Global trade is at a crossroads

The chief economist at the World Trade Organization, Rob Steiger, told Reuters that the global trading system stands at a “critical turning point,” pointing to four main challenges facing it: the widening distribution of economic power globally, the increasing interference of governments in national economies, and the transformations imposed by digitalization and global value chains on the nature of trade, in addition to the escalation of political frictions between countries.

He added: “The current rules are under mounting pressure, and this is already having a tangible impact.” If the multilateral system collapses at the global level, the scenarios we have prepared indicate that the economic costs will be very large.

These estimates come at a time when many countries are moving toward concluding special regional and sectoral trade arrangements, amid escalating trade tensions and the imposition of large-scale tariffs by the United States.

Last March, a group of the organization’s members agreed to move forward with the first basic set of rules regulating digital trade through a multilateral agreement, overcoming the objections of some members.

Steiger believed that regional trade agreements and limited multilateral initiatives may contribute to strengthening the global trading system, but he warned that they may become competing blocs that undermine this system if they move away from the multilateral framework.

He explained that the absence of a strong framework for the World Trade Organization may push these arrangements to direct trade towards preferred partners instead of the most efficient producers, and may also encourage trade blocs to erect new barriers in front of external parties.

He added that the organization's rules play an essential role in reducing discrimination against countries that are not members of trade agreements, and in controlling how free trade agreements are designed.

The organization indicated that uncertainty related to trade policies has reached unprecedented levels in recent years, with governments increasing use of customs duties, government support, export restrictions, and industrial policies.

Although about 72 percent of global merchandise trade is still conducted according to the “most favored nation” principle adopted in the World Trade Organization, compared to about 80 percent in 2022, Steiger described this decline as a “worrying trend,” reflecting the risk of the gradual erosion of the multilateral trading system.

As the Federal Reserve meets on Tuesday, Republicans face an economic test in which their ability to separate Middle East turmoil from domestic cost-of-living pressures in the United States is diminishing. The cost of war reaches the American voter in two ways: when paying fuel bills, and when requesting loans to buy a home or finance a business. Between these two burdens, the possibilities of tightening monetary policy stand out, at a time when the party needs to convince Americans that President Donald Trump’s policies are bringing them closer to prosperity.

According to the Federal Reserve's agenda, the decision is expected on Wednesday. However, the political impact is already beginning to show: rising energy costs threaten persistent inflation, while the prospect of higher interest rates raises concerns about the cost of curbing it. This complicates the question in an election year: When will citizens feel better about their situation if fighting rising prices requires slowing spending and raising borrowing costs?

Double burden

August data reveal the scale and limits of the problem. Consumer prices in the United States of America rose by 0.4 percent monthly and 3.4 percent annually, while gasoline prices rose by 3.9 percent during the month, representing more than a third of the total increase. According to the US Bureau of Labor Statistics, the annual rise in energy costs was 16.3 percent.

However, core inflation - which excludes food and energy - was 2.4 percent annually, down from 2.5 percent in July. These details prevent the situation from being reduced to an all-out crazy price rise scenario. While energy plays an important role, not all components of inflation are accelerating at the same pace. However, fuel shock is not limited to stations. Increased transportation and production costs could gradually be passed on to goods and services, putting pressure on corporate profits and consumers' budgets. A study conducted by the Federal Reserve explains how oil supply shocks can also raise basic prices when companies pass on part of their additional costs to consumers.

Borrowing costs add another layer of pressure. According to the Wall Street Journal, the yield on 10-year US Treasury bonds briefly exceeded the 5 percent barrier on Monday. Given the impact of these yields on long-term financing rates, loan conditions may tighten even before the Fed takes action, as market expectations change.

This does not necessarily recommend an immediate rise in payments for all borrowers, as holders of existing fixed-rate mortgages are protected from immediate changes. However, new homebuyers, those wishing to refinance their loans, and businesses seeking credit face a less favorable situation.

The “federal” dilemma

Reuters reported that major banks, including Goldman Sachs and JP Morgan, expect to raise interest rates by a quarter of a percentage point at their September meeting, in the wake of recent inflation data. Although these are pre-decision estimates, they reflect a shift in market sentiment, from the expectation of monetary policy easing to the possibility of it tightening.

The dilemma is that interest rates cannot repair a damaged pipeline or secure a sea lane. Central bank tools operate primarily through demand and credit channels: they increase the cost of spending and investment, and limit continued price increases. Thus, responding to an energy shock may have an economic cost without addressing the root cause.

Conversely, inaction can be costly if expectations of higher prices take hold and begin to affect pricing and wages. Amid these risks, the Federal Reserve's rationale for its decision becomes as important as the decision itself: Is the situation viewed as a temporary disruption that will resolve, or as ongoing pressure that requires a more sustainable response?

Politically, neither scenario presents a message that appeals to Republicans. Raising interest rates means continued pressure on financing costs, while stabilizing interest rates does not guarantee lower borrowing costs or fuel prices. Moreover, portraying the central bank as solely responsible for rising costs of living ignores the impact of energy prices, which precedes bank policy decisions.

Promises under pressure

The limited scope of quick fixes is evident in the position of Interior Secretary Doug Burgum. He stated on Monday, according to Reuters, that banning US oil or fuel exports will not necessarily lead to lower prices, and may lead to retaliatory measures that harm consumers. The administration is also looking at ways to increase refining capacity, knowing that industrial measures take time to affect supplies.

This highlights the dilemma facing the Republican discourse: while the administration can defend its security goals and emphasize the importance of domestic production, it must also clarify the contradiction between these policies and daily costs because pointing to the improvement of some economic indicators does not erase the financial pressure that families suffer from, as fuel and financing costs account for a large percentage of their income.

This gap provides Democrats with an opportunity to link war management with economic management, but it does not determine the final outcome of the vote. Voters weigh these factors with other issues such as jobs and income. However, the intersection of oil prices and interest rates places a tangible burden of proof on Republicans: offering a credible path to cutting costs in the few weeks remaining before the November election.

The Japanese yen is entering a decisive phase after its strongest rise in about 18 months. The continuation of its gains has become linked to the Bank of Japan’s ability to meet the expectations of the markets, which have raised the ceiling of its bets to levels that may be difficult for the bank to match, at a time when several fundamental factors are still tilting in favor of a weak currency.

The yen has risen by about 5 percent against the dollar since the beginning of the month, driven by a more stringent shift in the Bank of Japan’s speech, in addition to statements by US Treasury Secretary Scott Besent in which he called on the bank to “do the right thing” regarding monetary policy.

The buying wave was reinforced by speculation about the possibility that the Japanese Government Pension Investment Fund, which manages assets of about two trillion dollars, will return a large portion of its foreign investments to the domestic market. Last week, the yen reached 152.89 against the dollar, its strongest level in about 7 months. But this rise was based largely on expectations that the Bank of Japan may double the pace of monetary tightening, from increases approximately once every 6 months currently to raising interest rates approximately every 3 months.

High expectations

Markets are currently pricing in a path that could push Japan's interest rate above 2 percent within a year, from its current level of 1 percent. Analysts believe that this scenario raises the risk of investors being disappointed with the upcoming Bank of Japan decision. The bank may raise rates without providing strong enough signals to confirm the rapid pace of tightening that markets expect.

Masafumi Yamamoto, chief currency strategist at Mizuho Securities, said that the Bank of Japan will find it difficult to adopt a more hawkish stance than investors' current expectations, even if it raises rates at its next meeting. He warned of the possibility of the dollar returning to about 157 yen. Pointing out that a final interest rate exceeding 2 percent appears high, and may impose pressure on the Japanese economy.

The Federal Reserve complicates the picture

The future of the yen does not depend on the Bank of Japan alone. The return of bets on the US Federal Reserve raising interest rates after data showing expanding inflationary pressures is restoring support to the dollar. Markets now largely expect a US interest rate hike, with prospects for continued increases at a quarterly pace over the next twelve months.

If the Bank of Japan and the Federal Reserve tighten monetary policy in parallel, the yield gap between US and Japanese 10-year bonds may remain near 200 basis points. This gap has been a major factor in the weakness of the yen for years. Because it makes dollar assets more attractive than their Japanese counterparts.

Japan also faces an additional factor: the high cost of energy imports. The country relies heavily on imported oil, and the rise in prices due to the war in the Middle East puts pressure on the terms of trade and increases the demand for foreign currencies to settle the import bill.

A possible return to the “interest trade”

This environment may encourage investors to rebuild “interest trade” positions, which involve borrowing in low-cost yen and using the money to buy higher-yielding assets abroad. The recent rise in the yen has prompted widespread liquidation of such positions, but the end of a large portion of the liquidation operations means - in the view of some analysts - that the way has become open to rebuild selling positions on the Japanese currency. Data from the US Commodity Futures Trading Commission showed that speculative positions on the yen turned into net buyers for the first time since February, but this shift may be temporary if expectations of a Bank of Japan tightening decline. At the same time, Japanese investors are still directing significant funds to overseas markets. Ministry of Finance data showed that they pumped 1.3 trillion yen, or about $8.4 billion, into foreign stocks during August, which is the largest monthly shift towards foreign stocks in 5 months.

Pension fund bets

On the other hand, some investors are betting that the Government Pension Investment Fund will begin to reallocate its assets in favor of Japanese stocks and bonds, after the 10-year government bond yield rose to more than 3 percent for the first time in about 3 decades. Speculation increased after the “core portfolio” topped the agenda of a recent meeting of the fund’s board of directors, and after calls from Prime Minister Sanae Takaichi and Finance Minister Satsuki Katayama for increased domestic investment.

But analysts believe that the market may overestimate the size and speed of any transformation. The fund's governance framework requires it to limit the impact of its market movements, which means that any change in asset allocation will occur gradually and over a period of months.

Koichi Sugisaki, head of macroeconomic strategies for Japan at Morgan Stanley, said that any repatriation of funds from abroad will likely be a temporary inflow, similar to exchange market interventions, and will not change the fundamental factors that may push the dollar in the future towards 167 yen.

He also believes that the pension fund does not have a strong incentive to increase its holdings of local bonds, even with their yields approaching 3 percent. Because the fund's target return is higher when accounting for nominal wage growth.

The moment of decision

Thus, the yen's gains appear to be suspended between optimistic expectations regarding the Bank of Japan's tightening, and the possibility of the return of the factors that previously pressured it. These are the yield gap, the high energy bill, and the continued outflow of Japanese capital. The challenge for the Bank of Japan will not only be to raise interest rates; But also to convince investors that the upcoming pace of tightening will be as fast as the markets have priced in. If he fails to do so, the strong rise in the yen may quickly turn into a new opportunity to rebuild “interest trade” deals and bet on the currency’s decline again.