FTAdviser.com

Advertising

Good things come in threes, but bad things tend to gang up as well. In the space of 24 hours between 5-6 June, the markets received three very nasty shocks.

The first was the clear indication from Jean-Claude Trichet, the president of the European Central Bank, that interest rates were about to the pushed higher. Investors were completely unprepared for the move; they thought that rates could be raised later in the year but not this soon. then there was the sharp 0.5 per cent rise in US unemployment, which seemed to negate the generally improved tone of data in previous weeks. And finally there was the $10 surge in the price of oil, taking crude to a record peak above $139 a barrel.

In currencies, the news upset expectations for a broad dollar rally from the lows hit earlier in the year. After all, while the ECB may be set to increase rates, the Federal Reserve can hardly follow suit, in the light of such a sharp rise in unemployment. In part that prompted the rise in commodities, which are seen as negatively correlated with the US currency. For stock markets, the employment news revived the fears that the US might be sliding into recession.

The underlying problem is that the Goldilocks era may be over. It saw the ideal trade-off between growth and inflation – economic conditions were “just right”. But now that trade-off has deteriorated; we get more inflation per unit of growth.

This change may well be because emerging markets have moved from having bit parts in the global economy to assuming the lead role. And they, for various reasons, have been running a monetary policy that is too loose. As emerging market demand has pushed up commodity prices, developed economies are facing a “terms of trade” shock – the price of the things we import has risen faster than the price of the things we export.

Nations faced with a terms of trade shock can react in a number of ways. They can do nothing, in which case their trade deficits and inflation rates will rise. Or they can try to offset the shock by restricting demand, usually by raising interest rates. Such a policy may limit the impact on the trade deficit and on inflation, but at the risk of causing recession.

What we are now seeing is an interesting experiment in economic policy. The ECB is taking the traditional restrictive role; the Fed is hoping that the inflationary shock will be short-lived. The danger of the ECB's policy is obvious; parts of the euro zone, such as Spain and Italy, are already struggling. The danger of the Fed policy has already been explained. If developed country demand no longer sets commodity prices, then inflation may not fall even during a prolonged US slowdown.

One must add in to the mix the continued effect of the credit crunch. If conditions in London are anything to go by, the UK housing market is deteriorating sharply. In both Europe and the US, surveys show that banks are increasingly unwilling to lend. In America, the problems of the monoline insurers like MBIA and Ambac have not been sorted out.

These are the kind of shocks that I was warning about earlier in the year. Small wonder that the US stock market fell 3 per cent on 6 June; we are nearly halfway through the year and there seems to be no light at the end of the tunnel. We have only a couple of hopes to cling to. The first is that the conspiracy theorists are right; commodity prices have been driven up by speculators rather than fundamentals. The second is that the dramatic rate cuts made by the Fed last year are about to work.