Price pressures lurching out of control in Asia pose a new threat to global inflation, writes Stephen Roach

FEARS OF 1970s-style stagflation are back in the air. Global bond markets are growing ever more nervous over this possibility, and US and European central bankers are talking increasingly tough about the perils of mounting inflation.

Yet today's stagflation risks are very different from those that wreaked such havoc 35 years ago. Unlike in that earlier period, wages in the developed economies have been delinked from prices. That all but eliminates the automatic indexation features of the once dreaded wage-price spiral - perhaps the most insidious feature of the "great inflation" of the 1970s.

Moreover, as the stunning surge of the US unemployment rate in May suggests, slowing economic growth in the industrial economies is likely to open up further slack in labour markets, thereby putting downward cyclical pressure on wages over the next couple of years.

But there is a new threat to global inflation that was not present in the 1970s. It is arising from the developing world, especially in Asia, where price pressures are lurching out of control. For developing Asia as a whole, consumer price index inflation hit 7.5 per cent in April 2008, close to a 9½-year high and more than double the 3.6 per cent pace of a year ago.

Sure, a good portion of the recent acceleration in pricing is a result of food and energy - critically important components of household budgets in poorer countries and yet items that many analysts mistakenly remove to get a cleaner read on underlying inflation. But even the residual, or "core", inflation rate in developing Asia surged to 3.8 per cent in April, more than double the 1.8 per cent pace of a year ago.

Given Asia's new-found role as the world's producer, such an outbreak of surging inflation in this region is not without serious risks to the global economy. The globalisation of trade flows is a new transmission mechanism of worldwide inflation that was not evident in the 1970s.

According to estimates from the International Monetary Fund, overall exports should hit a record 32.5 per cent of world gross domestic product in 2008, more than 50 per cent above the export share of 21 per cent prevailing in 1980, when the "great inflation" was nearing its peak.

At the margin, that means cost pressures and price determination today are shaped much more in the global arena than they were during the domestically-driven stagflation of the past.

Asia's outbreak of surging inflation is especially problematic in that regard. Nowhere is that more evident than in China - the new engine of Asian output and exports.

Chinese inflation has surged at an 8.3 per cent average annual rate over the four months ending May 2008, the sharpest sustained increase on a year-on-year basis since the mid-1990s.

China's inflation problem is much deeper than the food and energy price shocks that thus far have played a disproportionate role in driving its consumer price index higher. Also at work are serious wage pressures reflecting, in part, increases in minimum wages associated with new labour reform laws. Meanwhile, the People's Bank of China has held its policy lending rate below headline inflation, resulting in negative real short-term interest rates.

The result has been an ominous increase in Chinese inflationary expectations, strikingly reminiscent of similar occurrences that plagued the developed world in the 1970s and early 1980s. History does not treat kindly a serious deterioration in inflationary expectations.

The longer such a trend persists, the more wrenching the monetary tightening required to arrest it - and the greater the risk of a subsequent hard landing. That is the last thing China wants or needs.

China is hardly alone in its reluctance to take firm action against a worrying build-up of inflationary pressures. That is true throughout most of developing Asia, where hyper-growth is viewed as the panacea for the aspirations of a growing middle-class. Throughout the region, central banks are keeping short-term interest rates far too low to combat these inflationary pressures.

For developing Asia as a whole, a GDP-weighted average of policy rates is currently about 6.75 per cent, fully three-quarters of a percentage point below the 7.5 per cent headline inflation rate.

Such monetary accommodation in an increasingly inflation-prone developing Asia spells a persistence of elevated price pressures in this vital segment of the global production chain. Not only does that threaten living standards for newly prosperous households in the developing world; it also takes an especially severe toll on those at the lower end of the income distribution. And, of course, it provides a price shock to imported goods in the developed world, which now play a much greater role in meeting the demands of domestic consumption.

Notwithstanding recent pressures in bond markets, the world remains largely in denial over the outbreak of a new strain of stagflation. The hopes of "core inflationists" depend on a reversion in food and energy prices to take headline inflation lower in the developing world. Yet this will be the sixth year in a row when that has not happened.

The "market purists" are counting on currency adjustments - especially sharp appreciation of currencies in developing Asia - to temper the transmission of price pressures from these export-led economies. Yet these are not economies that want to use the currency lever to put their growth imperatives at risk.

The risks of a new stagflation are mounting. But it will not be a replay of the 1970s.

Like nearly everything else in the world these days, this one is likely to be made in Asia.

Stephen Roach is chairman of Morgan Stanley Asia