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As U.S. President Donald Trump ratchets up his trade war with China and the Federal Reserve Board increases U.S. interest rates, the prospects for the world economy and financial markets, so bright just a few months ago, appear to be darkening.Last month, I highlighted three indicators – the oil price, long-term U.S. interest rates, and the dollar's exchange rate – suggesting that global conditions would remain benign. Despite the Fed's decision to raise short-term interest rates and to signal more rate hikes than expected for 2019, interest rates on U.S. 10-year bonds have fallen to levels well below their February peak. Thirty-year interest rates are now below their 2017 peak of around 3.25 percent. The fact that bond investors seem unworried about inflation or overheating does not mean that Trump's protectionism and fiscal profligacy are harmless. Financial markets are sometimes catastrophically wrong, as they were before the 2007-2008 financial crisis.Long-term interest rates of around 3 percent come nowhere near pricing in the Fed's inflation target of 2 percent plus the real economic growth of 2-3 percent that was likely to be achieved even before the Trump administration's big fiscal stimulus.If the U.S. economy continues growing as expected, is it not inevitable that long-term interest rates will surge to much higher levels, knocking the highly leveraged U.S., and ultimately the entire world economy, off its current path of strong and stable growth?
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