Analysis: The Iseq fell 2.9 per cent yesterday as stocks across Europe tumbled 3 per cent to their lowest levels in five months. It's happened before, most notably about three years ago, but this time there is more to worry about.
The falls were prompted by fears amongst traders that the Federal and European Central Bank (ECB) will raise interest rates higher than expected, thereby dampening growth in the US and Europe, and lowering future earnings and share values.
Ironically, an economic boom is the cause of all this. Traders are reaching for their security blankets because the surging economies of India and China are pushing up the prices of oil, copper, zinc and other vital commodities.
For India and China this is less harmful than in the US and Europe. Wages are higher in the West, markets less competitive, and central banks are more likely to react with higher interest rates, which slow growth. So in addition to the impact of higher interest rates on consumption and investment, higher commodity prices will increase business costs in the developed world.
Ironically, news of an improved European and US economy has added to fears of higher rate rises. Higher domestic growth adds to inflationary fears and when central banks react to the latter, they lower the prospects for future economic growth. That, in turn, hurts estimates of future company earnings flows upon which analysts base their estimates of share prices.
Why would central banks want to choke off future growth prospects? Speaking in Paris yesterday, ECB president Jean Claude Trichet answered this question, as well as hinting at the ECB's intentions on rates.
Inflation, he said, is not just caused by higher oil and commodity prices - about which governments can do nothing. It is also caused by a lack of competition in markets such as telecommunications and energy, about which they can. The ECB, he said, would be "very, very vigilant" on reforms that could improve productivity and inflation.
In other words, were inflation rising solely for reasons beyond government control, the ECB might sympathise. But if governments can indeed help the fight in inflation, but are refusing to do so, the ECB has to fight alone and this means fighting harder.
Trichet's messages are clear. Firstly, reform of product and service markets is the best antidote to long-term rising oil and commodity prices. Lowering the cost of living and doing business will undo some of the damage done to share prices by rising commodity prices. Secondly, if the ECB is forced to raise rates higher than expected it will be as a result of governments failing to reform. If this scenario arises, Trichet kindly requests that you direct your complaints to your nearest government, not to the ECB.
