The current rally in financial markets is being driven, and might well be driven further, by a sharp easing in monetary conditions after the May sell-off. Long-term rates fell in the US and Europe, and monetary tightening in Japan was more than offset by exchange-rate weakness.
So where do we go from here? One of the factors that could cause liquidity to contract is inflation. In the US, wages and salaries in the private sector grew at an annualized rate of more than 15% in the first quarter of 2006 and 8.5% in the second. The increases were fairly broad-based, including those sectors where bonuses do not distort the figures.
This might be a sign that liquidity-generated inflation is spreading from financial bubbles into the output economy. As US productivity growth is trending down, unit labour costs jumped 5% year on year in the second quarter of 2006. And unit labour costs are a reliable predictor of traditionally measured inflation.
| Inflationary pressures hit output |
| Capacity utilization in Germany, Japan and the US |
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| Source: Datastream |
Globally, policy interest rates are still lagging capacity utilization and labour markets, which are tightening fast.