As global growth moderates, the Fed’s policies on interest rates and quantitative tightening may cast a shadow on risk appetite in 2018.

Our central expectation is that 2018 will be similar to 2017. We expect decent global growth, continued tightening by the Fed, and a reasonable environment for risky assets. Still, the probability we attach to this central scenario is not very high. The biggest risk is the Fed moving too aggressively, especially since quantitative tightening could have a greater impact on growth.

For the United States, the Fed is the question

While the risk of a recession remains low in the United States, the most likely route to a slowdown is inappropriate monetary tightening. An overly aggressive Fed could produce a sharp downturn in the economy. The risks of this are higher because the Fed is raising rates and shrinking its balance sheet, which puts upward pressure on short-term interest rates. It is widely believed that yield curve inversion is the best leading indicator of a recession, and the relentless flattening of Treasury yields since September has raised worries about a change in the cycle. The risk is the Fed makes a mistake, and a hawkish mistake seems to be far more likely. Part of what the Fed wants to achieve involves greater asset market volatility, and there is a chance they’ll get more of this than they would like.

Despite the risk of an overly aggressive Fed, the U.S. economy’s prospects for 2018 is expected to be a bit better than 2017, buoyed by consumption and investment. The labor market is strengthening, and households’ real income and corporate investment may rise in 2018. The tax reform will also create some upward momentum in growth for an economy that was already reasonably strong: The economy expanded at a 3.3% annualized rate in the third quarter, the fastest pace in three years. Consumer spending and corporate fixed investment grew a combined 2.5% so far in 2017, and we see few downside risks to this growth pattern.

We see few downside risks to this growth pattern.

Eurozone and China may take breathers

There will be modest downside risks to growth in the eurozone and in China in 2018. China’s economy avoided a sharp downturn in 2017. However, challenges include the pace of reforms, the restructuring of state-owned enterprises, and the question of whether a centralized political system can run an economy at the technological frontier. Given the tighter monetary policy expected from the Fed and the possible appreciation of the dollar in 2018, there are likely to be renewed outflows from China. There is also the possibility of a range of actions by the Trump administration targeting the trade imbalance between China and the United States.

The euro area had better growth figures than expected in 2017, reaching a pace of 2.6% in the third quarter, supported by Germany’s exports, France’s business confidence, rising corporate investment, and strong growth in the periphery countries. However, the eurozone will have trouble sustaining that pace of growth. Recovery among the periphery countries is slowing, the strength of the euro will likely impede growth, and Germany will provide minimal fiscal boost.

Global inflation continues to surprise

The trajectory of inflation provided many surprises in 2017. Core inflation was weaker than expected by many central banks, especially the Fed and the ECB. Fed policymakers have dedicated a lot of time to trying to figure out inflation’s puzzling weakness, with little to show for their effort. In 2017, the Fed’s preferred core personal consumption expenditures (PCE) inflation measure dropped sharply, reaching 1.3% in August and 1.4% in the past few months. Among eurozone countries, core inflation fell to 0.9% over the past two months, defying ECB and market expectations that a new range of 1.1% to 1.2% would hold.

The Fed is going to be playing a risky game in 2018.

Will higher rates be the new normal?

Of course, central banks do not coordinate their policy actions, except in extraordinary circumstances. Still, there are some common themes at work here. Many central banks, including the Fed, the Bank of England, and the Bank of Canada, raised rates in 2017. We expect the Bank of Japan’s (BoJ) monetary policy to remain unchanged. However, there are signs the BoJ may change its stance at some point in 2018. The ECB has given a dovish tilt to its rate actions. Still, it will start tapering in 2018 — reduce its bond-buying program — and there is the likelihood the ECB will increase the deposit rate in 2018, even as the main refinance rate remains at zero.

The Fed will be the focus in 2018, especially in the first half, as it steps up the pace of tightening by shrinking its balance sheet, and as a new Fed chairman takes office. As this happens, we are worried about a move back to a normal global monetary regime due to concern about the longer-term trends in the economy, including demographics, the global disinflationary impulse, and high levels of corporate debt. The U.S. economy’s capacity to deal with much higher interest rates is limited. The Fed is going to be playing a risky game in 2018.

Next: Tax cuts trickle to GDP

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The acceleration in global growth witnessed in 2017 will continue well into 2018, but with significant changes in its components.