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Financial world still in turmoil; in association with RBS.


WHEN the 'credit crunch' first erupted over a year ago, the world's central banks were quick to react. They had, so it seemed, 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 unwelcome reappearance of a beast from the past - inflation - central banks' options are now much more limited. Interest rate cuts are now firmly off the menu.

And if policymakers want to tighten monetary policy, through raising interest rates - as the European Central Bank (ECB) did last week - then this carries the risk of undermining any recovery in growth. The Bank of England will decide tomorrow whether it wants to follow the ECB's lead.

We believe that it won't, and will continue to keep rates on hold; nonetheless, inflation control will remain at the top of its agenda.

The year on year rate of UK consumer price inflation hit 3.3% in May, the fastest since 1997.

Do economic fundamentals, at a global level, warrant central banks' inflation concerns? One way to approach this question is to ask whether the global economy already had incipient inflation problems, before the recent surge in oil prices.

Data suggests that the global economy was running at, or close to capacity at the end of last year - making it vulnerable to an oil price shock. The difference between actual and sustainable output has not been small for some time in both Europe and the US, with unemployment close to structural lows.

And many developing countries seem to be running above their non-inflationary speed limits, with rapid recent growth in both wages and prices. In the developed world, slower growth may now help ease some of these inflationary pressures, at least in terms of wages or capacity utilisation.

But in the developing world, these wage-price spirals could turn very nasty, and policymakers there often seem reluctant to deal with the underlying causes. If these wage-price spirals were to spread to the developed world (which we do not think would happen) this really would be a return to the stagflation of the 1970s. So, all in all, policymakers' concerns seem more than justified - inflation is a problem, and there are no quick fixes.

The way that policymakers respond to these myriad problems will be key for markets in the months ahead. On the positive side, we think that markets have overreacted: interest rates are unlikely to rise by as much as they have priced in, and we still think that the BoE could cut rates towards the end of this year.

But oil prices will not fall fast, and inflation will only peak later this year at best.

So the world, and UK, does not look as healthy a place as it did three months ago. Central banks - and the market - will be on full alert for some time yet.

Andrew Miller is the head of the Newcastle office of Barclays Wealth

"Data suggests the global economy was running close to capacity at the end of last year
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Publication:The Journal (Newcastle, England)
Date:Jul 9, 2008
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