Twelve months ago, the consensus view was that the world was on the verge of an economic meltdown, deflation was about to start stalking the land, and interest rates couldn't tumble fast enough. Today, market concerns have swung to the opposite but equally irrational end of the fear spectrum. The doomsdayers now tell us excessive global growth is about to lead to a break-out of nasty price pressures.
This thesis suggests that central bankers are going to have to push interest rates substantially higher in order to keep the inflation genie in the bottle.
Moreover, because monetary authorities have supposedly allowed inflation to regain a foothold and delayed raising interest rates, the tightening of policy necessary to restrain prices will be relatively severe. Interest rate setters, most obviously the US Federal Reserve, are allegedly behind the curve.
Fears of a dramatic sweep higher in global interest rates are always corrosive of market sentiment. Furthermore, markets, by dint of tradition, are inclined to volatility and nervousness during the month of October. Mix these drivers together with some Y2K liquidity concerns and you end up with a potent recipe for market underperformance which last month pushed the Dow Jones index to a six-month low and propelled 30-year bond yields to a two-year peak. In recent days, a sense of calm has returned on the back of some subdued inflation indicators. The key issue now is whether this new-found serenity is a passing fad or a return to rational analysis.
1999 has been a year of impressive performances by the world's leading economies. Rather than heading for some class of economic Armageddon, we are now witnessing a rebalancing of growth as the leading European economies and Britain respond to the stimulus offered by low interest rates.
Meanwhile, in the US, the pace of economic activity appears to be moving back to a more sustainable and non-inflationary clip. After three years during which growth averaged 3.7 per cent per annum, such a moderation in economic activity is to be welcomed. Across the globe, growth is reverting to a normal setting. The merchants of gloom will tell us that the problem is inflation rather than growth and will eagerly point to commodity market developments as a justification for their concerns. A quick glance at the behaviour of oil markets suggests that there is some validity to these fears with the price of crude doubling over the course of the past 10 months. However, our return-to-normality theme provides a useful analytical framework here again with oil prices merely adjusting to stronger global growth having collapsed during the emerging markets' turmoil. With producers now tempted by the price recovery to increase supply, oil prices are likely to edge lower again over the coming months.
Rising commodity prices only become a major problem when they begin to impact on popular inflation expectations and wagesetting behaviour. With consumer prices and wage inflation remaining remarkably muted, despite the tightness of labour-market conditions, there is scant data support for the view that inflation readings are about to head dramatically higher.
As the emerging markets' crises become a fading memory, we are bound to see inflation readings reverting to a normal level. The pick-up in price pressures is an adjustment shudder rather than the beginning of a trend. The benign mix of strong growth and low inflation which has delighted the markets in recent years appears to be intact.
Having cut US interest rates by 0.75 per cent in reaction to last year's global economic panic, the Federal Reserve has responded to the improved international environment and the enduring strength of domestic activity by moving short-term interest rates 0.50 per cent higher in recent months. At face value, a monetary policy tightening of this magnitude would not be sufficient to dampen the US's hectic growth. However, the US economy is far more susceptible to changes in long-term interest rates which have surged by 1.3 per cent over the course of 1999 as emerging markets panic faded to be replaced by inflation tensions. Mr Alan Greenspan, chairman of the Federal Reserve and the undisputed master of the monetary policy game, also played a role in bond market developments by using well-timed verbal interventions to prod yields higher.
The increase in bond yields is now feeding through to a slowdown in the interest-sensitive housing sector with home sales and overall construction spending growth moving decisively lower. This development is also being reinforced by a diminishing wealth effect as equity and property market returns edge lower. With an easing of pace working its way through the economy, is it any wonder that the Federal Reserve is dragging its heels on reversing the final interest rate cut of last year? The upside potential for US interest rates from here is limited. While official interest rates are set to be increased in November by 0.25 per cent, the Federal Reserve is likely thereafter to sit on its hands for some months.
Mr Greenspan and his colleagues can now afford to relax, watch economic growth moderate, inflation remain subdued and congratulate themselves heartily on another outstanding policy performance. We await the markets' plaudits.
Colin Hunt is chief economist at Goodbody Stockbrokers
