Bears in the woods

If you meet a bear in the woods, try not to panic or scream; on no account should you turn your back and run. As markets around the world have turned grizzly over the past two weeks, some investors seem to have forgotten the old hikers’ maxim. After three years of big gains, many stockmarkets have tumbled by 10% or more in less than ten days…The recent jitters need not harm the world economy, which even bears admit has performed stunningly. World GDP has grown at an annualised rate of more than 4% for 11 consecutive quarters…This is the strongest upturn for more than 30 years. Yet global inflation remains historically low. Strong growth with mild inflation is all the more amazing given the tripling of oil prices since 2003…

The world has so far shrugged off higher oil prices with the help of two powerful economic forces. The first is the opening up and integration into the world economy of China, India and other emerging economies. This has given the biggest boost to global supply since the industrial revolution. Their cheap labour has cut the cost of goods. The threat that jobs in rich economies could move offshore has helped hold down wages. Although demand from emerging economies has fuelled the surge in oil and commodity prices, the newcomers’ overall effect has been to curb inflation in the rich world. That, in turn, has magnified the second stimulus. Since the bursting of the dotcom bubble, central banks have pumped out cheap money. In 2003 average short-term interest rates in the G7 economies fell to their lowest in recorded history. Because inflation remained low, the central banks have been slow to mop up the excess liquidity…Together the huge boost to supply (from emerging economies) and the huge boost to demand (from easy money) have offset the burden of higher oil prices, creating the once-impossible combination of robust growth and modest inflation…

Excerpted from ‘The Economist’, May 25