Investors are caught between the desire for growth and the fear of inflation POOR Goldilocks is suddenly out of sorts. After five years when economic conditions have been, like baby bear's porridge, “just right”—strong growth and low inflation—they are now spoiling fast. And as central banks begin to react vigorously, investors are taking fright. When 2008 started, most investors assumed that the lingering effects of the credit crunch would allow interest rates to fall, or at worst be kept on hold. But over the past week markets have priced in a number of rate rises later in the year from the Federal Reserve, the European Central Bank (ECB) and the Bank of England. That has caused turmoil in short-term government-bond markets (see chart), as yields have been forced sharply higher. The problem is inflation. Central bankers may hope that soaring oil and food prices will prove to be just a blip, and will not result in secondary effects such as higher wages. But they know that higher inflation expectations, once entrenched, are difficult to eliminate. So they are sounding as tough as they can. Tricky Trichet This has not been well co-ordinated. On June 3rd Ben Bernanke, the chairman of the Fed, tried to talk up the dollar (a falling currency adds to inflationary pressures). But on June 5th Jean-Claude Trichet, the ECB president, gave a strong hint that euro-zone rates were soon to rise. That sent the euro sharply higher. As Albert Edwards, a strategist at Société Générale, put it: “Only [two days] after Bernanke made his dollar-supportive comments and retreated to the sidelines, he received the studmarks from Trichet's boot in his chest.” If that central-banking snafu was not bad enough, June 6th saw both an unexpected rise in American unemployment and an $11 gain in the price of oil—a combination that points to higher inflation and slower growth. Small wonder that the Dow Jones Industrial Average tumbled nearly 400 points on the day. Investors fear that central banks, in their zeal to prove their anti-inflationary credentials, may inflict some severe damage on economic growth. The problems of the financial sector are far from over, as the $2.8 billion second-quarter loss at Lehman Brothers illustrated. Its share price continued to take a hammering this week as investors worried about its balance sheet and business model. There have been few bond defaults as yet, but Stephen Dulake, a credit strategist at JPMorgan, reckons investors may be looking in the wrong place for trouble; there have already been 26 defaults in the American corporate-loan market this year. Credit spreads (the excess rates paid by risky borrowers), having fallen sharply between mid-March and mid-May, have been edging higher again. Meanwhile, house prices are falling in America and Britain. Consumers are struggling to cope with the impact of that on their wealth and with the effect of higher fuel and food prices on their wallets; a rise in interest rates may push them over the edge. In the global economy, more bad news came on June 11th: Australian consumer confidence and New Zealand home sales fell to 16-year lows. Nor is the task of balancing inflation and growth confined to the developed world. In China the central bank raised the amount of reserves banks must hold against their loans, in an effort to restrain inflation, and shares fell for seven days in a row up to June 12th. Inflationary fears led India's central bank to raise interest rates for the first time in more than a year. In essence, the global economy has received two shocks in the past 12 months—the credit crunch and higher commodity prices. Those shocks have made the outlook more uncertain, not just for the economy but for monetary policy. And uncertainty makes investors nervous, not least because it comes after a long period when markets seem to have underpriced risk. “Recent years have seen the world get all the benefits of globalisation without the costs,” says Peter Oppenheimer, a strategist at Goldman Sachs. “Emerging markets got growth, developed countries kept the lid on inflation.” But higher commodity prices are a zero-sum game; for every winner, there is a loser. Many of those losers are likely to be companies. Profit margins have been at historic highs in some big countries, in large part because businesses have been successful in controlling labour costs. But higher raw-material prices present firms with a problem. Pass those costs on, and not only will consumer demand falter, but central banks may raise rates. So they may have to accept lower margins instead. At the start of the year analysts were forecasting 15% profits growth for European companies in 2008. Revisions have brought that number down to 4%, largely because of problems in the finance industry. But Goldman Sachs thinks analysts are still too optimistic; it is predicting an earnings decline of 12% this year. A combination of higher interest rates and lower profits makes it difficult to see how stockmarkets could advance much during the rest of the year. Currency markets are also likely to be volatile. The Fed would like to engineer a rise in the dollar against the euro and the yen and a fall against the developing Asian currencies. But that will be hard to pull off as central banks around the world grapple with the inflation/growth trade-off. The dollar's yield will continue to look unattractive, since American interest rates are likely to remain lower than most (bar Japan's). The Bank of Canada, which was widely expected to cut rates this week, decided to keep them steady. And government-bond markets may also be set for turmoil. Analysts have been scratching their heads at some of the recent moves. “If we told you that the Dow fell by 400 points one Friday after the largest rise in the unemployment rate in nearly three decades, would you buy or sell two-year Treasury notes?” asks William O'Donnell, a strategist at UBS. The usual response would be to buy, but investors sold. Expectations of higher short-term interest rates trumped the safe-haven appeal of the bonds. At the ten-year level, it may seem odd that investors are willing to receive a Treasury-bond yield of just 4.1% when headline inflation is 3.9%. But if the American economy slips into recession, ten-year yields could fall a lot lower than that; they were 3.1% in June 2003. So, a world without Goldilocks would be a harsh one for investors. It is not a place where bears eat porridge and go for strolls in the wood. It is one where bears eat ingénues for breakfast.