World central banks face dilemma

The world economy is facing the risk of both recession and higher inflation.

Global growth this quarter and next may be the slowest in four years, while inflation might be the highest in a decade, economists at JPMorgan Chase & Co. say.

The worst U.S. housing slump in 16 years, coupled with a tightening of credit by banks, has brought the world's largest economy "close to stall speed," according to former Federal Reserve Chairman Alan Greenspan. At the same time, rapid growth in China and other emerging markets is driving energy and food prices higher worldwide.

According to Joachim Fels, co-chief global economist at Morgan Stanley in London: "What lies ahead is a period of stagflation - slow or no growth combined with rising inflation - in the advanced economies."

Harvard University economist Martin Feldstein is among those who say it would be just a mild case of what the world endured in the 1970s and early 1980s, when a tenfold increase in oil prices drove both unemployment and inflation above 10 percent.

Still, it poses a dilemma for the Fed and other central banks as they struggle to decide which problem they should tackle first: a slumping global economy or rising prices worldwide.

"Central banks don't have as much flexibility as they'd like, with inflation rising and demand slowing," said David Hensley, director of global economic coordination at JPMorgan Chase in New York. His team sees global economic growth at 2.4 percent this quarter and next, and inflation at 3.5 percent. Both are worrisome figures - growth too slow and inflation too high.

Still, that is a far cry from 1982, when world growth slowed to just 0.7 percent while inflation ran at an annual rate of 13.7 percent, according to the International Monetary Fund.

Even so, experts such as Greenspan are concerned. Speaking on ABC's This Week program Sunday, he said a period of "remarkable disinflation" was ending. "We are beginning to get, not stagflation, but the early symptoms of it," he said.

Through the first 11 months of this year, U.S. consumer prices rose at an annual rate of 4.2 percent. That's up from 2.5 percent for all of 2006 and, if maintained in December, would be the highest in 17 years.

"The numbers are scary," said Stephen Cecchetti, former director of research at the Federal Reserve Bank of New York and now a professor of international economics at Brandeis University's International Business School in Waltham, Mass.

It isn't just a U.S. concern. Inflation in Europe last month was 3.1 percent, the highest on an annual basis since May 2001, as food costs soared.

"The oil-price boom and rising food prices have clearly accelerated inflation developments since summer," Austrian central bank Governor Klaus Liebscher said in Vienna on Friday.

Surging food prices are also pushing up inflation in China. Consumer prices in the world's fastest-growing major economy were 6.9 percent higher last month than in November 2006 for the highest year-over-year increase in 11 years.

Behind the burst of inflation: rapid growth in emerging markets that is lifting prices worldwide for a broad range of products.

If the global economy faced only the risk of higher inflation, the policy prescription would be clear: higher interest rates.

But with growth slowing in the United States and Europe, central banks remain under pressure to cut rates. The Fed has already reduced its benchmark rate a full percentage point in the last four months, while the European Central Bank has held borrowing costs steady rather than raising rates as previously planned.

"I'm not going to put a happy face on the slowing U.S. consumer," Jeffrey Immelt, chief executive officer of General Electric Co., told analysts in New York on Dec. 11. "Our businesses that touch housing in the U.S. are going to be challenged."