Expert View: 'Inflation vigilantes' will be disarmed

Listen to some commentators and you'd think we were making a return to the 1970s. Inflation is hitting the headlines as oil prices soar and the global economy heats up. Can it be only a year ago that people were talking about precisely the opposite? As with last year's deflation scare, the current inflation panic is likely to prove short-lived.

Listen to some commentators and you'd think we were making a return to the 1970s. Inflation is hitting the headlines as oil prices soar and the global economy heats up. Can it be only a year ago that people were talking about precisely the opposite? As with last year's deflation scare, the current inflation panic is likely to prove short-lived.

At first sight, though, there's something in the comparison with the 1970s. Led by the US and China, the global economy has been surprisingly strong. Commodity prices have surged higher and the US has has stoked up demand with successive rounds of tax cuts. And to cap it all, oil prices are making a run to record levels.

Not surprisingly, the "inflation vigilantes" in the bond market have been out in force in the past few weeks. With signs that consumer as well as commodity prices are accelerating in the US, the Federal Reserve has been accused of complacency.

Yet while it is hard to deny that inflation is turning up, what the Fed's critics seem to have overlooked is that, for the first time in a generation, it was actually aiming for higher inflation.

It didn't put it so bluntly, and it only wants a little bit more inflation - say, from 1 to 2 per cent - but after the collapse of the stock market three years ago, the Fed has been living in fear of a repeat of the stagnation and deflation that the Japanese have experienced since their bubble burst in 1990.

The near panic in the financial markets over the prospect that the Fed will soon start to raise interest rates will reinforce the Fed's concern about the vulnerability of the economy to a renewed tumble in asset prices.

Thus, while it is likely to oblige the inflation vigilantes over the summer by starting to lift rates, it's likely to proceed gingerly. If the financial markets fall too sharply in response, the stream of rate rises that the markets are now expecting could be put back.

But even if the markets take higher rates in their stride, the idea that the current cyclical upturn in inflation is likely to turn into a more lasting 1970s- style problem is fanciful.

A distinctive feature of the latest economic upswing, at least outside Europe, is how far it has been led by capital expenditure. Much of this has been devoted to price-destroying new technology. You can see this most dramatically in China. While its veritable orgy of investment has forced up the prices of all sorts of primary commodities, when the resulting manufacturing capacity comes on stream, it's not inflation that we will be worrying about.

Now that the Chinese government is taking steps to cool its overheating economy, the world could be about to face a disinflationary double whammy of slowing Chinese demand combined with rising Chinese supply.

Meanwhile, the most recent surge in oil prices has had less to do with the strength of global growth than the specific terrorist threats to the supply chain and the general resurgence of geopolitical risk.

Beyond the imminent boost to headline inflation, this will depress consumers and their purchasing power, driving inflation back down again. This is especially true given that labour markets generally remain slack (the UK being an exception) and wages subdued. Give it another year, and the commentators may be back to fretting about deflation.

The author is chief economist, ING Financial Markets