When the credit crunch erupted last year, the world's major central banks were quick to react. They had, apparently, almost a blank cheque to deal with the problem: interest rates could be cut repeatedly, or large amounts of liquidity fed into the world's financial system, often via new vehicles. But, with the reappearance of a beast from the past – inflation – their options are now much more limited, said Michael Dicks, Managing Director and Head of Research & Investment Strategy at Barclays Wealth.

"Monetary policy may need to be tightened, but with the risk of undermining growth. So, while we expect some sort of US equities turnaround over the summer, as fiscal easing kicks in, we are gloomier about the prospects for 2009. Accordingly, we are reducing risk and staying close to home," Dicks said in the July issue of Signpost, the bank's monthly report.

The deeper question is whether economic fundamentals, at a global level, warrant central bankers' renewed inflation concerns.

"In order to do that, we start by asking if the global economy already had incipient inflation problems before the recent surge in oil prices took place. For if it did, the oil being poured on troubled waters increases markedly the chances of a proper inflation taking place – in the sense of a wage-price spiral happening. In order to help answer the question, we consider three different gauges of spare capacity:

The output gap – defined as the difference between the actual level of GDP and its sustainable (or 'potential') level, measured as a percentage of the latter. As no data exist for potential GDP, it has to be estimated, usually with recourse to a production function. In other words, economists look at the main inputs to the economy's production processes – capital and labour – and gauge how efficiently they have been combined in the past to produce value-added output. They then assess, given current resources, how much the economy might be able to produce were everyone gainfully employed and all capital (comprising such things as factories and machinery) in use.

Capacity utilisation – defined on the basis of surveys, in which managers are asked such questions as 'at what levels are you operating your workers and machines currently?' The capacity utilisation indices provide a gauge of how many firms are reporting that they have little or no spare capacity – in other words that their operating rates are so high as to risk them being unable to boost output further without bidding up the cost of inputs (such as workers or machinery).

Unemployment gaps – defined in an analogous way to the output gap, but with reference to the labour market. Here the idea is that there is a 'structural' level of unemployment (but not zero), at which workers will accept wages rising in line with prices, so that wage and price inflation will be stable. Push actual unemployment below this level and workers will be in short supply and thus able to (successfully) exert upward pressure on wages. If, on the other and, there are more unemployed workers than the structural (or 'natural') level, this excess supply will ensure wage pressures diminish.

The important thing about all these measures is that they try to ascertain when aggregate demand is being pushed beyond the economy's ability to supply."

"For a situation in which that happens, at least for any sustained period of time, is likely to lead to the prices of resources being bid up. Figures 1 and 2 illustrate what we mean, in a stylised fashion: when actual GDP moves above its (upward rising) trend – i.e. it moves above potential GDP – and the output gap thus takes on positive values, then inflation usually starts rising above its trend rate.

Whereas five years ago the global economy appeared to have a significant amount of spare capacity – which would generate downward pressure on inflation – by the end of last year that position had changed to one in which there was little if any underutilised or unused resources in aggregate (Figure 3).

Thus the global economy was operating at its maximum speed limit, and so vulnerable to any shocks that came along which might depress supply and/or raise price pressures. And, of course, just such a shock – the sudden surge in commodity prices – is precisely what did come along. This has had two deleterious impacts. First, it forced up the cost of living for households. Second, it led to a surge in firms' costs, which has hindered their ability to generate profits, unless of course they pass-on the cost increases to consumers by raising the prices that they charge for the goods and services produced by them.

There is one potential silver lining to this particular cloud. If the IMF's estimates are accurate, then the position of the output gap being fully closed was reached towards the end of last year. However, during 2008, many economies have shown signs of growing less fast than previously – and less faster than potential.

Next consider the emerging markets' output gap estimates made by IMF staff (Figure 4). These are the hardest to estimate, given the paucity of data and their low quality. Nevertheless they provide a clear warning, suggesting that marked changes in operating rates have come about in recent years. Five years ago, raising output in Asia and Latin America to the tune of 4 or 5 per cent of overall capacity was not a problem, it now appears that all that spare capacity has been used up. Indeed, it may well be that many of these economies are already running with demand above their non-inflationary speed limits. Given the sheer speed with which they have shifted from one regime (of lots of room to grow) to another (of being up against their ceilings or breaking through them), and given too the fact that it is in these countries where the estimates are of the poorest quality, if there is an inflation genie that has been let out of the bottle, then he is an 'emerging' one.

The way that policymakers respond to the problems facing them will be key for markets in the months and quarters ahead. On the positive side, we sense that markets have overreacted to news that central bankers have switched their attention – from worrying about how much to ease to how much to tighten. ECB governing council members have been explicit in saying that a 'nudge on the tiller' is being considered, in order to demonstrate the seriousness with which it takes its price-fighting mandate. But that is very different from saying it is embarking on a series of upward adjustments to the policy rate, as markets have priced in.

Last of all, and perhaps most important of all, concerns the way that the authorities act in the emerging world. Worryingly, that tendency has gone hand-in-hand with a reluctance to raise official interest rates too in much of the developing world and, in some cases, a tendency to let fiscal policy ease in the face of higher food and oil prices – even when faced with an already large fiscal deficit. That may have helped prevent many of the poorer elements of society from being impacted as severely as had the public subsidies not been boosted. But the failure to let market forces rip comes at the cost of letting demand rise above supply, requiring further monetary tightening to curb overall price pressures. The pain of adjustment cannot be avoided. The longer the problem is ignored, the bigger the ultimate cost of getting things back on an even keel



MARKET CONFIDENCE AT LOW EBB

A few months ago it was thought that, despite a difficult macro-economic backdrop, market confidence would gradually return. And, for the first half of the second quarter, so it did, with the MSCI index rising by a little over 10 per cent, says the Braclay's report.

But these gains have subsequently evaporated: stock markets are now lower than when the Fed stepped in to save Bear Stearns. The recent gloom is due in large part to the reappearance of inflation. Central banks are now focused on defeating this beast, with interest rate cuts firmly off the agenda, despite continued evidence of macroeconomic distress.

Many emerging economies may now be operating above their non-inflationary speed limits, as evidenced by the emergence of wage-price spirals. If these were to spread to the developed world, then it really would be a return to the 'stagflation' of the 1970s. We have trimmed our global GDP growth forecast to just under three per cent in 2008. This would be the weakest outturn since 2003, but not a bad result by historical standards. US growth is forecast at 1.2 per cent, with that of the euro area and UK at 1.7 per cent and 1.5 per cent respectively. We remain concerned about 2009.

Fundamentals remain the main driver of commodity prices, although speculation and geopolitical tensions are also helping to push up oil prices. Sterling may temporarily stabilise as the Bank of England treads a tightrope between inflation and growth over the next few months. But it will soon flounder again. The US dollar has also been looking rather healthier of late, but it should weaken again later in the year. The euro is likely to remain strong for the remainder of this year, but the situation could change in 2009.