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Forget the bulls, the herd is in charge

When a new neighbour moved in recently and we got together for a glass of fruit juice, almost the first question he asked, when he learned about my trade, was: ”And what’s the economic outlook?”

I fear I came out with a classically cautious ”on the one hand and on the other” response. He looked disappointed. ”I’m a City trader,” he said. ”What I like is volatility.”

”Well, there should be plenty of that,” I said.

And how! The financial markets have been going up and down like yo-yos.

In case the reader thinks I am being wise after the event, or boasting, I should point out at this stage that the above conversation took place at the beginning of last year, not 2006, so I was a bit out in my timing.

At all events, when the financial news hits the front pages, you can be sure that a lot of people are worried.

And here we come to one of the most important influences on the financial markets: the herd instinct. This applies to professional traders and economic analysts as much as to the general public. Often they dare not be caught out if everyone else seems to be buying or selling, so they join the rush.

What we are witnessing now is the inevitable reaction to a prolonged bull market. Relatively low interest rates have for some time now encouraged speculative buying.

Experts such as William White, the chief economist of the Bank for International Settlements (the central bankers’ bank in Basle, Switzerland), have been expressing concern that the putatively magic world of successful inflation-targeting is not enough, and that, while targets have been achieved, masses of liquidity have been pumped into the financial system.

This has stimulated speculative buying of everything from oil to basic metals and gold, as well as pushing up share prices. Froth was added to the system in recent years by the so-called ”carry trade” in which professional speculators and hedge funds borrowed cheaply, most notably from Japan.

There, in order to emerge from deflation the monetary authorities kept interest rates close to zero and ”invested” in high interest rate countries as far dispersed as New Zealand and Iceland.

More generally, we have witnessed several years when United States citizens were remortgaging their houses at low interest rates to keep up a pace of consumer spending that was not obviously justified by the growth (or lack of it) in average real incomes, and investors worldwide were plunging into riskier and riskier assets.

At some stage something had to give, and there are various explanations for what has caused the recent bout of nervousness. Perhaps the most convincing is the sudden realisation that the US Federal Reserve, or rather its chairman, is not, after all, some kind of god.

And before blaming it all on the new chairman, Ben Bernanke, we perhaps ought to note that within days, yes days, of departing from the Fed, its retired ”god”, Alan Greenspan, was indicating that the markets had been overdoing it. Since the overdoing took place on his watch, this was pretty damn rich.

Nevertheless, Bernanke is the favourite whipping boy at present, partly because he has not been as opaque as Greenspan in his public pronouncements.

But the fact of the matter is that the combination of the latest oil crisis and the accompanying boom in other commodity prices has driven inflation up above the comfortable levels of recent years. So-called ”core inflation” has also edged up (core inflation has nothing to do with apples, but is adjusted for, well, ”volatile” prices such as energy costs).

So Bernanke’s arrival and communication problems have coincided with concern about inflation and how central bankers may react. Suddenly it’s not enough to assume that cheap imports from China will keep inflation under control.

It’s bad luck on Bernanke. But then the fact of the matter is that it was absurd to invest his predecessor with mystical powers. Welcome back to the real financial world. — Â

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