Bird flu and Sars were once touted as potential worldwide pandemics, but inflation is now the threat keeping global policy-makers awake at night.

In a speech earlier this month, the South Korean president warned the global economy is facing its stiffest test since the oil shock of the 1970s as soaring commodity and food prices spark protests and riots in countries both rich and poor.

Among the nations most affected by rampant inflation are the booming Gulf states, most notably the UAE and Qatar, while the new economic powerhouses of China and India are facing up to slowing growth as inflation saps their competitiveness.

In Vietnam, interest rates have hit 14 per cent as monetary policy struggles to contain price expansion that is galloping at 25 per cent. Developed markets are also feeling the squeeze as the twin threats of stagnating growth and rising prices leave policy-makers in a fix. On the one hand, central banks are urged to reduce interest rates to stimulate consumption to kickstart flagging growth.

On the other, rate increases are demanded to put a brake on rising prices.

This phenomenon is reawakening the spectre of stagflation, which last blighted the world in the late 1970s, although most economists believe the global economy is now better equipped to overcome these problems. "We have to recognise that inflation is not just a Gulf story, it's an emerging market-wide phenomenon," said HSBC economist Simon Williams.

"Whether it's Asia, Latin America or the Middle East, there has been a significant pick-up in both consumer and asset prices.

"The drivers are similar across the board – rapidly increasing domestic demand, coupled with a rise in commodity prices and, in many cases, sustained currency weakness. These are all feeding through into a troubling inflation dynamic. The real growth story in the Gulf is more resilient than in other markets. While other emerging markets are talking about stagflation, I don't see that being such an issue here in the Gulf."



Far from over

For Paul Rawkins, senior director, Fitch Sovereign Ratings, the global rise in inflation is far from over. He said: "Food and energy prices will continue to be high and a lot of countries are facing up to the fact that subsidising these costs is no longer sustainable. By and large, the immediate response has been to tighten monetary policy, with countries raising interest rates in a move that will slow growth.

"Oil and food is the other side of the equation. In the longer term there must be a supply response. Meanwhile, increased export taxes have exacerbated the problem. Inflation is probably the biggest challenge facing the world economy."

Global growth is slowing as a downturn in the United States, together with troubles in the United Kingdom and eurozone economies reduce demand for Asian-produced consumer goods.

Tightening credit conditions and rising prices are also restricting real investment and consumption. The European Commission has admitted inflation was the principal economic worry after data showed prices in the 15 countries using the euro rose a record 3.7 per cent year-on-year in May, up from 3.3 per cent in April.

HSBC's Williams said: "The global inflation story still has some way to run, but as the global economy slows we should see some easing of the pressure on commodity prices, particularly if the dollar recovers as HSBC expects."



Demand-supply imbalance

Many factors have been blamed for soaring commodity prices, but the prime cause has simply been extra demand from the world's fast-growing emerging markets, with supply unable to keep up. Steel, cement, oil, gold and other metals have hit historical highs amid fierce competition for resources.

Williams said: "There is a major shift in the global economy that is seeing emerging markets gain a larger share of global wealth than they have ever previously enjoyed. That is filtering through into rapid growth in emerging market consumption. This extra demand is exerting strong pressure on global commodity prices.

"It's nothing less than a tectonic shift in the global economy and whenever change of this scale takes place there is some pain and dislocation as the market adjusts – the inflation dynamic is a reflection of this."

Commodity prices are likely to slacken in the second half of 2008 and into 2009 as global growth slows and demand falls, but Williams warned supply side adjustments are needed to tame rising inflation in the long term. Fitch's Rawkins agreed, saying: "In the short term, slower growth promises to be part of the adjustment process; over the longer term, the world needs to see a supply-side response."



Dollar peg

The causes of inflation vary across the globe. In the UAE, the main drivers are a huge demand-supply imbalance in real estate and other assets and services, plus imported inflation as a result of the dirham's peg to the dollar. The UAE is facing a double whammy, with rising inflation in exporter countries such as China, India and the eurozone increasing the cost of goods from these countries, while the declining value of the dollar has reduced the purchasing power of the dirham to buy these higher-priced imports.

The UAE dirham is fixed to the US dollar and so the UAE must follow American monetary policy even when this runs contrary to economic wisdom.

The US has reduced borrowing rates from 5.25 per cent to two per cent since September and the UAE has been forced to follow suit, fuelling money supply and asset-price inflation. The latest numbers released by the UAE Central Bank show that total money supply, or M3, increased by almost 40 per cent in the year to March, reaching a staggering figure of about $750 billion (Dh2.7 trillion).

HSBC's Williams added: "In the Gulf there is a strong argument for currency reform to rein in inflation, but it will only be effective if it is part of a broader programme to slow the pace of demand growth and moderate liquidity. Fiscal policy is just as important a tool, alongside structural reforms that will boost competition and move the region toward a more fully functioning market economy."



No easy solution

If the UAE raises interest rates above the Fed benchmark, this would attract capital inflows which would further fuel inflation. Other nations that raise interest rates will face a similar problem and so there's no easy solution.

"It's a difficult balancing act for the oil producers of the Gulf because the long-term consequence is that inflation becomes embedded in the system, which will make their non-oil sectors less competitive," said Fitch's Rawkings.

"Meanwhile, Asia has not been a high-inflation region and it depends on exports; so it's vital to retain competitiveness, which is under threat from inflation," he said.

For emerging markets, rising inflation will also worsen income distribution as food prices rise, which of course will hit the poor hardest.

Fitch forecasts oil prices will fall next year as high prices squeeze consumption and, therefore, ease the supply-demand imbalance. However, the Organisation of Petroleum Exporting Countries, or Opec, has been vociferous in claiming there is adequate supply and the recent oil-price increase is the result of speculation.





MEASURED RESPONSE

The UAE has long been maligned for the paucity of its inflation statistics. Unlike Bahrain, Qatar and even Yemen, the UAE does not produce a monthly inflation monitor, instead publishing an annual figure with the 2007 official inflation rate announced only this week.

Many economists have complained the criteria the UAE uses to measure inflation, which are based on a 10-year-old study in Abu Dhabi, are wholly inaccurate and understate the real rate of inflation.

However, the 2007 figure of 11.1 per cent was higher than many economists' forecasts, which has led some to believe the UAE is now measuring inflation seriously, while a monthly index is in the pipeline.