Why the markets are behaving so strangely

It is as if one were walking in a forest during January, snow on the ground but the hawthorn in flower

After a crash, everybody hopes to get back to normal. I happen to be referring here to the savage, prolonged downturn in the global stock market that touched bottom during the Iraq war and which has since eased. I could as well have in mind any other traumatic event, such as a major illness, or a war. The sentiment is the same. The teasing question, however, for central banks, businesses and savers is which normal times are we returning to. Are we going to encounter once again economic circumstances resembling the early 1990s when the bull market began? Or is "normal" an older pattern going back a century or more? Later this week, the US Federal Reserve will, through its interest rate decision, show which account of normality it thinks is the more realistic.

For the moment, financial markets present some strange sights. It is as if one were walking in a forest during January, snow on the ground, but the hawthorn was in full flower, four months early. Or as if one glanced upwards and saw that swallows were mingling with winter geese. Thus risky equities have been rising at the same time as safe-as-houses bonds. Usually these very different types of security make up a seesaw; if the one is up, the other is down. Moreover, you don't generally see interest rates on the floor but not the slightest sign of accelerating inflation. Nor, in these circumstances, would you ever expect to see the gold price rising, as it has been. Gold is the supreme hedge against inflation. If consumer prices are stable, or tending downwards, as they are at present, then the best thing to do with gold bullion is to melt it down and turn it into jewellery rather than to buy more of it.

Rarely, too, does one hear an American Treasury Secretary talking about the dollar in such uncaring terms that his insouciance serves only to make the currency plunge further. We see a flight from the dollar. Dollar imperialism, a feature since the Second World War, is being soft-pedalled just at a moment when American power is reaching out across the world as never before.

What these strange juxtapositions tell us is that each of the two schools of thought about what the future holds have numerous followers. In one camp there are those who believe that the economic cycle is continuing to work as it has done throughout all our lifetimes, even though the bull market lasted an unusually long time and the subsequent correction has been more painful than usual. At last, these people would say, normal service is being resumed and so an early recovery in economic activity can be confidently expected. They believe that the familiar cycle, though probably much less extreme than 1992 to 2002, has started all over again. The essential component of this narrative is that inflation is ever present and is always likely to accelerate. Professional investors holding this view of the world are buying shares.

In the other camp are those who say, "Hang on, can't you see that we are returning to a different kind of normal service. The great inflation that began in the early 1960s and continued through the 1970s and 1980s, and which petered out in the early 1990s, was an unusual episode in economic history, not normal at all, and what is reasserting itself is a much older pattern, bouts of inflation alternating with periods of deflation, as was the case for hundreds of years." And adherents of this school of thought say that because the world has forgotten how to cope with falling prices, the first bout of deflation, when it returns, will be very painful. It could substantially depress business activity. People with this view are buying bonds.

Each school has its natural followers. The community of financial executives that makes its money from high levels of stock-market activity desperately wishes the first school to be right. In their lifetimes they have enjoyed ever increasing job opportunities and accelerating salaries. They certainly don't want to find that their experience has lost its value. But if a pattern in which bouts of deflation alternate with inflation were to reassert itself, they rightly fear that exuberance would drain away from financial markets and with it the clamour for their services.

Those who spend most time considering the arguments of the second school are central bankers. They are charged with safeguarding and maintaining the value of their national currency. In many countries, including the United Kingdom, the central bank is actually responsible for issuing notes and coins. And while the Bank of England hasn't shown a lot of concern about the possibility of deflation, the US Federal Reserve worries out loud about how such an eventuality can be prevented. That is why the decision it will make on 25 June is so significant.

For followers of the first school would argue that there is no need to cut interest rates any further. But if the US Federal Reserve does, none the less, cut its primary interest rate to what would be a new 50-year low, then it will be a sign that it fears that the second school may be right, that back to normal means a return to the economic conditions of the 19th century and the first half of the 20th century and that the period 1965 to 1995 wasn't normal at all.