A lot of investors are currently worried about stagflation. While I agree that the risk of a US recession has increased, I don't think that we are in an environment of structurally higher inflation.

Stagflation is a term used by economists to describe an environment of high inflation combined with slow economic growth or even recession. It came to be known as an economic problem in the 1970s, a period when the oil shocks led to high inflation at a time of weak growth. Stagflation poses a dilemma for central banks because easing monetary policy (lowering interest rates) to improve growth may produce higher inflation and tightening monetary policy (raising interest rates) to fight inflation may weaken growth.

The January numbers for the Consumer Price Index in the US and in Europe seem to confirm the widespread concerns about inflation. In the US, the inflation rate stood at 4.3%, compared to 1.9% in August of last year. For the Euro Zone, the corresponding numbers were 3.2% and 1.7%. At the same time, the Federal Reserve has made it clear that it currently sees the fight against recession as its main priority and that it is therefore prepared to dramatically ease monetary conditions. It thus seems safe to predict that inflation can only continue to rise, leading to a 70's-type situation.

There are however significant differences between today's environment and that of the 1970's.

First of all, the deterioration in the inflation numbers is due to a very large extent to high energy and food prices. The rise in these prices reflects long-term structural changes in both supply and demand. Central banks have no control over these changes and raising interest rates will not make them disappear. This explains why central banks and economists often look at the "core" inflation rate, i.e. the Consumer Price Index excluding food and energy. At 2.5% in the US and 1.7% in the Euro Zone, these core inflation numbers do not look very worrying. They haven't increased over the last 12 months. People obviously have to eat and buy oil or gas but if higher food and energy prices don't lead to wage growth (see below), they mean that consumers have less money to spend on other things, with prices of these 'other things' declining.

Secondly, unless commodity prices continue to rise strongly, inflation numbers will gradually improve. Inflation is basically about year on year comparisons and in the second half of this year, these comparisons for commodity prices will be from a much higher base. At the end of February, the oil price stood at $102, compared to $68 at the end of February 2007 so the year on year rise in the oil price was 50%. If the oil price stays at current levels, oil price inflation in October will have dropped to 13% (in October 2007 the oil price was at $90) and at the end of the year will be virtually zero.

Third, the main structural force behind the rise in commodity prices - globalisation - also explains why higher commodity prices have not led to rising labour costs and to a price-wage spiral. Globalisation increases the available workforce and the productivity of that workforce. It also leads to more competition, less union power, industry deregulation and economic reforms, all of which are disinflationary. Also wages in most countries are not index-linked any more meaning that the mechanism through which higher commodity prices quickly lead to higher unit labour costs is no longer there.

Fourth and finally, an environment of credit contraction, falling house prices and declining economic activity is simply not conducive to demand-led inflation.

To sum up, investors currently have a lot to worry about but structurally higher inflation is not the issue.