Behind the turmoil in financial markets

Outside the US, economic activity has for the most part been stronger than expected, particularly in China. That has also been the case in Australia where, as the Reserve Bank noted in explaining its decision to lift the cash rate to 6.5 per cent on August 8, the non-farm economy is growing at an above-average pace in circumstances where there is very little spare productive capacity left.

In that context, as demonstrated by the higher-than-expected outcome in the June quarter, the risks to the outlook for inflation are on the upside. Indeed the Reserve Bank raised its forecast for underlying inflation for the year to June 2008 to 3 per cent, the top of its inflation target band. Given the manner in which the Reserve Bank formulates its inflation target this effectively means that the Bank sees some risk of inflation exceeding the target over the next 6-12 months.

Hence the possibility of another increase in Australian interest rates cannot be dismissed - and Reserve Bank Governor Glenn Stevens has been quite explicit in ruling out the suggestion that the Bank would be dissuaded from raising interest rates again in November, if it thought that were necessary, by the possibility that the election campaign might be in full swing at that time. Of course, in making that judgment, the Reserve Bank will be influenced not only by the outlook for inflation but also by the extent to which the interest rates actually paid by borrowers have been pushed up by market forces. Depending on whether the current degree of extreme “risk aversion” persists, the Bank may decide to defer consideration of any further increase in interest rates until early February.

Whatever the eventual outcome, the dramatic turn of events in financial markets over recent weeks has provided a timely reminder of the trade-off between risk and return. For much of the preceding four or five years, many investors had taken on increasing amounts of risk in order to enhance returns in an environment where yields on more conventional investments had fallen to unusually low levels. In many instances, it would appear (and not simply with the benefit of hindsight) that investors did not fully appreciate the nature or extent of the risks to which they were exposing themselves.

At the time of writing, sentiment has swung too far in the opposite direction - lenders and investors are hesitating to take on any risk at all: a stance which if sustained for any length of time would inevitably have serious consequences for the operation of the financial system and for the level of economic activity.

It is thus in everyone’s interests that central banks and other authorities succeed in their efforts to restore a sense of normality in financial markets. But equally, if investors remained more cautious in their assessment of the risk-return trade-off than they had been prior to these developments, that would be no bad thing.