Warning signals make Federal Reserve ultra-cautious

We have reached one of those occasional critical junctures in the world economy, one of those multiple forks in the road where, for both policymakers and markets, choices really do matter.

One road threatens inflation.

Another risks a possibly serious economic slowdown.

And a third, the worst of all worlds, leads in Escher-style madness to both destinations.

Why have we got to this point? A few months ago, inflation was a concern, but the concern was seemingly both marginal and manageable.

At the time, the global economy was remarkably buoyant, seemingly unperturbed by persistent increases in US interest rates.

Financial markets were robust: bond yields had risen only modestly, the dollar had been relatively stable during a period of widening global imbalances and equities continued to make strong gains, fuelled by attractive valuations and continued good news on corporate profits.

This inflationary concern seems recently to have evolved.

Central banks are more worried now than they were a few months ago.

The Fed's recent language increasingly sounds like that of the ultra-cautious European Central Bank: central bankers are keen to show their "vigilance" in the light of mounting price pressures.

They have a lot at stake: after all, the last thing they want to see is an erosion of their hard-won anti-inflation credibility.

Inflation, though, is no longer the only worry.

Although in many parts of the world, growth is strong, the country with the biggest influence on the global economy - the United States - has shown the first tentative signs of reacting to earlier interest rate increases.

In particular, the housing market has begun to soften, suggesting that monetary policy is beginning to bite.

So we have evidence both of mounting inflationary pressures and, simultaneously, a slowdown in growth.

This is not the kind of mix that financial markets like.

Investors have shown their distaste by lowering their exposure to risky assets: that means the sale of equities in general and, in particular, the sale of emerging market equities.

Despite good growth, stable inflation and healthy balance of payments surpluses, emerging markets have yet to lose completely their old reputation for being only fair-weather friends.

The easy view to take is simply that the slowdown in growth is a necessary condition to ensure that inflation, eventually, comes back under control.

What we're seeing are snapshots of the economy at different points in time.

Higher inflation this year reflects strong growth last year.

Weaker growth this year indicates lower inflation next year.

On this view, inflation is like the light from a distant star: we're only able to see it with a time delay.

But if it were as simple as that, it's difficult to see why markets have suddenly become a lot more nervous.

Perhaps the current situation can be better described in terms of uncertainty.

It may be that higher inflation this year is a result of last year's strong growth, and it may be that this year's weaker growth means lower inflation next year.

But we don't know these things for certain.

And with uncertainty comes a greater risk of policy error.

Here are two plausible scenarios.

First, central banks believe that any slowdown this year is sufficient to bring inflation under control.

They therefore stop raising interest rates.

Inflation, though, continues to rise, thereby suggesting that central banks paused too soon.

Policymakers' reputations are left in tatters.

Second, central banks are convinced that the increase in prices seen so far will inevitably lead to wage hikes.

Because of this inbuilt inflationary threat, policymakers tighten policy aggressively.

The wage threat, though, doesn't come through and the economy, faced with brutally high interest rates, collapses.

Neither of these is very nice.

Both depend on errors of judgement.

Yet either scenario is plausible.

How do central banks choose between them? The easiest way is to make a careful assessment of changes in inflation expectations.

If they're stable, the chances of a sudden inflation-threatening rise in wages is probably rather low.

If, instead, expectations are on the rise, central banks are likely to become a bit more cautious.

Latest data, unfortunately, suggest that inflation expectations are, indeed, beginning to head upwards.

There are all sorts of ways of measuring these expectations, none of which is perfect.

Most of the expectations indicators, though, have edged up in recent months.

The charts provide a few examples.

US consumer confidence surveys have all shown a heightened appreciation of inflation risks.

Bank of England surveys of public inflation perceptions have pointed to much the same thing.

Financial markets have also become a bit more twitchy, with movements in inflation-protected bonds pointing to a bit more nervousness in recent months.

So it's not so surprising that central banks are hinting at a more trigger-happy mentality towards interest rates.

They simply cannot be seen to be taking too many risks with inflation: allowing inflation expectations to rise is a risk too far.

For the Federal Reserve, there are additional worries.

Ben Bernanke, the Federal Reserve chairman, has often said that his preferred measure of inflation - the one he presumably would choose as an inflation target if ever US monetary policy were to head in that direction - is the so-called core personal consumers' expenditure, which excludes food and energy prices.

That number has edged up in recent months, but it still remains relatively well-behaved compared with the headline inflation measures that matter to most of us.

I suspect, though, that Mr Bernanke may be wondering whether the core measure really is the right thing to be looking at.

After all, if energy prices keep increasing, helped along by strong growth in China, India and other emerging markets, these gains are surely going to have some impact on the public's expectations of inflation.

So perhaps the Fed, like the European Central Bank and Bank of England before it, will increasingly regard changes in headline inflation as a guide to possible changes in inflation expectations.

And with inflation on this measure up at 3.5 per cent, it would not be surprising if Mr Bernanke were feeling a touch uneasy at the moment, particularly at a time when the Fed has found it difficult to get a clear message across to financial markets.

At the margin, then, the rise in inflation expectations explains the more hawkish tone coming from central banks around the world, and suggests another few months of rate increases to come.

Whether actual inflation will rise is, of course, another matter altogether.

There's plenty of evidence, for example, that companies are offsetting energy price increases with labour cost reductions, suggesting that a 1970s wage-price spiral is an unlikely event.

For markets, though, the combination of uncertainty and a higher level of interest rates to ensure that inflation remains well-behaved is a rather bearish cocktail: even if the global economy keeps growing, it looks as though financial markets are, at the very least, suffering from growing pains.

* Stephen King is managing director of economics at HSBC.

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