Events are moving apace in the financial markets. The US Federal Reserve signalled this week that it is approaching the end of its rate-raising cycle. The European Central Bank raised rates for the first time in five years earlier this month. Recent economic data indicate the Bank of England may well be forced to cut rates next year.

Meanwhile, many developed equity markets are trading close to multi-year highs. The spread (excess yield) on emerging market bonds is around a record low. Gold and other metals prices have been surging.

Throw in the fact that the real yields on both conventional and index-linked bonds are trading at fairly low levels, in historic terms, and you have a fairly confusing picture.

It is tempting to explain the picture in terms of optimism about growth alongside worries about inflation in the coming years. That would explain the strength of equities and commodity markets, but not the apparent sang-froid of bond investors, who are the supposed vigilantes of the system.

One possibility is that the bond market is being distorted by the purchasing patterns of Asian central banks and pension funds. They are keeping yields artificially low.

The problem with that thesis is that such factors have been around for ages. In recent weeks, however, the break-even inflation rate (as measured by the gap between index-linked and conventional bond yields) has fallen just as commodity prices have been peaking. There seems no reason why the Asian banks and pension funds have suddenly got a lot more involved in the bond markets in recent weeks.

That leaves the possibility that the bond market is a bubble. For a market to be a bubble requires investors to be irrational. Is it possible for one part of the market (commodities) to be rational while another part is not?

Even if it is, market reports suggest one reason for the surge in the gold price was the enthusiasm of Japanese retail investors, diversifying from the weakened yen. So we have to believe that Mr and Mrs Watanabe represent the smart money and the likes of Pimco, the bond giant headed by Bill Gross, is the dumb money. This stretches plausibility a bit.

A more likely explanation for the recent trends in financial markets, in my view, is that there is a lot of money sloshing around the system. This money is finding its way into lots of homes, which explains why bond yields are low and equity and commodity prices are high.

The immediate inflationary pressures do not look that great. Headline rates are now edging down again, as the $10 a barrel drop in the oil price is working its way through the system. Core inflation rates did not appear to be showing any evidence of “second order” effects; in other words, high oil prices are not being passed on. The latest US numbers indicate that unit labour costs are under control; there was actually a 1 per cent fall in the third quarter.

However, one can make a perfectly respectable argument that the money sloshing around the system is already causing inflation (in asset prices) and will eventually lead to a more general rise in the price level. Indeed, some argue that the official consumer price indices understate the inflationary level.

One can bolster this argument by pointing to the high levels of debt in the US and the UK. Eventually, this debt will cause a problem and the temptation will be for central banks and governments to inflate their way out of it.

But a quite ingenious counter-argument comes from George Cooper of JP Morgan. He likens the economy to a central heating system, with the money supply acting as the boiler, the inflation rate as the temperature and the central bank acting as the thermostat.

Cooper argues that if the boiler is running at full blast but the temperature inside the house is still low, that indicates the outside temperature is very low. In other words, for rapid money supply growth to be producing only low inflation levels indicates plenty of deflationary pressures.

The opening up of the Asian markets to the global economy has given a one-off profit boost to the corporate sector, allowing them to keep labour costs down. Hence the absence of the overheating that usually occurs when developed economies expand for too long.

At some point, the balance may be tipped in one direction or another. Perhaps US consumption will falter, thanks to a weaker housing market, dragging the world into recession. Or perhaps Asian consumer demand will surge, turning the continent into a source of inflation rather than deflation.

These are very long-term questions. They might be resolved in 2006, or the world could muddle through for another year, with both the inflationists and the deflationists finding sustenance for their theories.

The mere fact that the peak of the US interest rate cycle may be 4.5 or 5 per cent indicates that times have changed considerably (the last peak was 6.5 per cent). Some worry that the ECB may be overdoing things if it allows rates to get to the heady levels of 3 per cent.

That would seem to indicate both that inflationary pressures are subdued and that economies are too fragile to allow central banks to really tighten the screw. Over the long term, that may suggest the deflationists will get the better of the argument. So don’t sell all your government bonds just yet.

philip.coggan@ft.com