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Twelve months ago as the credit crisis first began to unfold, there was a widespread belief that global economies could de-couple. A collapsing US housing market seemed inevitably to precipitate a sharp slowdown, if not recession, in the US economy. But it was hoped that the rest of the world, driven by Chinese-led growth, would help cushion that downturn. That this has come to pass has proved something of a blessing and something of a curse.

The blessing is that continued growth in Asia has indeed helped buoy the US economy. Net exports have, on average, added just over 1% to US GDP growth over the last five quarters, a contribution which almost exactly offsets the drag on growth from declining residential construction over the same period. Weakening domestic demand coupled with a further 10% decline in the real value of the US dollar over the last twelve months has helped produce a marked improvement in the US external trade account. Were it not for the spiraling oil price, the US current account deficit could have improved even further. The latest balance of payments figures indicate that the current account deficit has fallen to just under 5% of GDP from a peak of about 6.5% two-and-a-half years ago. Stripping out oil, the deficit has fallen from around 4.5% to 2.5% of GDP over the same period.

The curse is that still strong growth in Asia, the oil exporters and other natural resource-rich economies has led to global demand for raw materials remaining strong. As a consequence, commodity prices, food and energy, in particular, have continued to rise: oil has doubled in price on a year ago; foodstuffs are on average up 60%; and industrial raw materials are up 27%. Only metals, which hitherto had been rising strongly, have shown some signs of leveling off in recent months. This has meant that cost-push pressures in the mature western economies have continued to intensify even as demand has slowed. And while this is technically imported inflation over which western central banks have little or no control, headline inflation has been stubbornly persistent while producer prices have accelerated at rates not seen for more than a decade. So far such pricing pressures have not fed noticeably into wage demands but there are signs that inflationary expectations are on the rise and the fear is that if left unattended, a wage-price spiral could develop.

As a result, western Central Banks are faced with a dilemma. Do they continue to cut interest rates in response to accumulating signs of weaker economic growth, falling asset prices and excessively tight credit, or do they act preemptively on inflation by putting up interest rates so further slowing economic growth, reinforcing the decline in asset prices and potentially adding to the dysfunction in the credit markets. Perhaps not surprisingly, the European Central Bank has been the first to pass judgment. Having resisted the temptation to cut interest rates in the preceding twelve months, it raised interest rates by 0.25% at the beginning of July. A 4% provisional estimate for headline inflation in June (twice the official target rate) together with stubbornly high broad money and credit growth were sufficient to sway ECB policy makers. So far, the US Federal Reserve and the Bank of England have talked tough but refrained from action. At best they are likely to sit on their hands for the next month or so to see how their respective economies move before acting. However, markets are now betting that the next move in rates in these countries may be up not down. The early move by the ECB may serve to affirm these judgments.

A better solution would be for the Central Banks in Asia and the oil-exporting countries to take a more proactive stance on monetary policy. This is where demand is strongest and this is where inflationary pressures are at their most intense. Indeed, what might look like a case of stagflation in Europe and America is old-fashioned demand-pull inflation in the emerging markets. All the classic symptoms are present: overheating economies, rising inflation, negative real interest rates and rampant money growth. Intervention to maintain currency competitiveness has boosted the money base and facilitated rapid credit growth in these countries. And this process has accelerated. Foreign central bank holdings of US dollar assets have risen by 18 % on a year ago. Over the first half of this year, they have risen by 28% on an annualised basis and over the last three months they are up by 34%. It is not surprising that money growth in many Asian economies is running at 20% p.a. or more. As a result EM CBs are finally starting to tighten and this may be expected to continue.

Dogmatic monetary targeting may have fallen out of favour because financial innovation has made the leads and lags in the system so imprecise. But, to quote Milton Friedman’s famous dictum, “inflation is always and everywhere a monetary phenomenon”. Action by Central Banks in Asia and the oil exporters to tighten monetary policy would help to quell commodity price inflation. It would of course also dampen global growth but, in so doing, would mitigate some or all of the need for the west to tighten policy at time when its financial system is in need of a prolonged period of convalescence.