John Rapley

Obscure though it might seem, yesterday's inflation reading in the United States could bode ill for the global economy.

The credit crunch continues, as bank lending seizes up around the world. Traders are clamouring for the world's central banks to ride to the rescue, cutting interest rates so as to pump liquidity into the global system.

The problem is, inflation is rising almost everywhere. Injecting more money into the world economy would risk aggravating that. An interest-rate cut could therefore have a perverse effect: investors in government paper, anxious that central banks had lost their inflation-fighting nerve, might sell their holdings. As they demanded higher interest on treasury paper, long-term interest rates might rise around the world.

Traders in the major financial capitals have pinned hopes of rescue on one principal thing.While inflation is rising in Europe, China, India and other major economies, in the U.S., there remains a hope that it might ease. This is because the economy has slowed, and the housing bust could diminish consumption.

On the other hand, productivity is slowing and labour costs are rising. Meanwhile, commodity prices, if they are no longer surging, remain high. All this inflationary pressure in the pipeline suggests that sooner or later, firms will pass their rising costs on to consumers in the form of price rises.

Those shouting for interest rate-cuts say that the decline in the U.S. housing and stock markets will so slow growth that firms will have no choice but to discount prices. They suggest that the greater risk to the U.S. is not inflation, but recession, and they want action now.

However, the U.S. Federal Reserve Board maintains that it will hold fire until inflation clearly shows it is moving downwards. And yesterday's reading, if modest, suggests that inflation in the U.S. remains stubbornly above the Fed's comfort zone. It will probably take more evidence that the U.S. economy is heading for recession before the Fed gives traders what they want.

Repressed labour costs

Of course, the Fed may cave into pressure and grant the screamers on the financial television channels their wish. It would probably be a mistake. What we are witnessing is arguably the unravelling of the 1990s boom.

Then, repressed labour costs enabled firms to drive up profits. When labour costs finally started rising around the turn of this century, share prices fell as workers got a bigger share of the pie.

But central banks, rather than let things play out, rode to the rescue and dropped interest rates. This rescued the world's stock markets. But it also pumped so much money into the world economy that inflation - in property and commodity markets, and now in labour and consumer markets - began to reappear.

The best course of action, in countries like the U.S. where a housing decline is under way, might be for the government to come to the assistance of the most vulnerable homeowners. But a wholesale bailout by the central bank would only postpone the day of reckoning once again.

The truth is that in the U.S., things might not be as bad as the stock-pickers are saying. Ordinary Americans might suffer from retreats in their home prices. But provided they can hold on to their properties, they will benefit from their increased power in labour markets: the long-term prognosis for wage growth has actually turned in their favour for the first time in a generation.

What the prophets of doom are arguably demanding, therefore, is a bailout of the billionaires. But a shakeout in world financial markets, by pricking the bubbles once and for all, would probably do the world economy some good.