Dovish King takes it softly on inflation

In 1965, Iain Macleod coined the term 'stagflation' to describe the combination of slow growth and high inflation, noted Chris Giles in the FT. Today it is back in the news, with growth weakening and inflation hitting the same level that prompted him to devise the expression. Consumer price inflation (CPI) hit an annual 3.3% in May, the highest since the index's inception 11 years ago.

The rise in CPI to more than 1% above target meant Bank of England governor Mervyn King had to write his second letter of explanation to the Chancellor since the current target was instated in 1997. There will be more soon. A letter must be written every quarter if inflation remains above target and it is likely to climb above 4% this year, says King.

Pain now or later?

In a relatively dovish letter, King blamed global commodity prices for much of the rise. He appeared to rule out an abrupt rise in interest rates, as this would cause "unnecessary volatility" in output and employment "for which read a recession", as Jeremy Warner put it in The Independent. King expects inflation to subside as squeezed household incomes and the credit crunch highlighted again this week when yet more banks raised mortgage rates or withdrew deals slow the economy, said Patrick Hosking in The Times.

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But the danger with King's softly-softly approach, said Willem Buiter in The Times, is that "the high and rising inflation expectations of the past months will become firmly embedded" and only be dislodged by a "long and deep slowdown". King seems to be opting for "less pain up front" but "more pain cumulatively", versus "more pain upfront" but less in total.

Stagflation is everywhere

Britain isn't the only country grappling with impending stagflation. Eurozone inflation has hit a record 3.7% amid slowing growth, while US producer prices are up 7.2% year-on-year. They have now been above 6% for eight months on the trot, the longest stretch since the stagflationary era of 1977-1982.

Meanwhile, housing starts hit a 17-year low. Asia is also struggling with stagflation. Slower Western consumption and rocketing oil and food imports are crimping exports, while Stephen Roach of Morgan Stanley points out that inflation in developing Asia hit a nine-year high of 7.5%; minus food and energy, the rate is still 3.6%, having doubled in a year.

And central banks aren't clamping down: the region's average interest rate is below the inflation rate. Given "Asia's role as the world's producer", a "price shock" to imported goods in the economically weakening developed world is on the cards. The risks of a new stagflationary era are mounting. Like pretty much everything these days, "this one is likely to be made in Asia".