Stephen King: Inflation fears have vanished – suddenly it's all about growth

Manufacturing surveys from around the world provide a miserable message – growth momentum is fading

Earlier in the year, it seemed as though inflation was the big problem. In response, the European Central Bank raised interest rates. The hawks on the Bank of England's Monetary Policy Committee wanted to follow suit. And many investors thought that, before the year was out, the US Federal Reserve would do exactly the same. How things change. Suddenly, fears about inflation have vanished. The big problem now is growth. Surveys of manufacturing activity from around the world provide a consistently miserable message: the momentum of economic growth is fading. And while that's a welcome result in parts of the emerging world where inflation really has been a threat, it's a lot more worrying for nations in the developed world where recovery is still in its infancy. If the pace of expansion in the US and in many parts of Europe was already disappointing, the situation now is even worse.

On one level, this is all rather surprising. With interest rates more or less at zero, with massive budget deficits and with central banks throwing caution to the wind by turning on their printing presses, the amount of economic stimulus seemingly on offer is huge. So why hasn't it worked? Let me offer an analogy. Imagine it's been snowing and the roads are icy. You are driving up a hill. Close to the top, you have to stop at a junction. But when you attempt to move off again, you find that the wheels merely spin on the ice. You have no traction. The harder you try, the worse it gets. The car is stuck. You have plenty of power, but that power is totally ineffective. Eventually, you have no choice but to abandon your car. What follows is a long, slow and very cold walk.

Policy-makers have much the same problem. Their policies have little traction. Faced with large amounts of debt – either in the private sector or, increasingly nowadays, in the public sector – people are simply unwilling or unable to respond positively to the inducements on offer from central banks and governments.

The Keynesian "reset" – the idea that a big stimulus would allow an economy to "jump" from a high unemployment setting to a full employment setting – just hasn't happened. The clearest example of all this comes from the US. On Friday, we learnt that American employment rose a mere 54,000 in May and that unemployment had gone up to 9.1 per cent. Even worse for a nation with a long tradition of "fire and hire" – and, yes, I deliberately put the words in that order – many US citizens are struggling to find new work. The result has been an unprecedented rise in long-term unemployment.

With all this weakness, it's no surprise that investors are no longer convinced that central bankers will be raising interest rates any time soon. One way to measure this is to take a look at 10- year government bond yields. In effect, they are a sum of expected future levels of short-term interest rates. Investors have recently decided to put their misgivings about the US budget deficit to one side and, instead, focus on the weakness of the US economy, figuring that interest rates will now be lower for longer. Reflecting this new thinking, 10-year yields momentarily dropped below 3 per cent at the end of last week, suggesting growing doubts about the pace of recovery.

You might think that the continuation of very low interest rates for a while longer might be a good thing. It isn't. A healthy economy full of vitality and the joys of risk-taking should have relatively high interest rates. Only those economies unable to stand on their own two feet experience continuously very low interest rates. Low interest rates today are not a sign of future strength but, instead, of ongoing current weakness. There is little credit supply, even less credit demand, insipid money supply growth and miserable fiscal austerity. Housing markets, meanwhile, are no longer able to deliver the turbo-charged recoveries of old.

To be fair, things could have been a lot worse. Faced with the biggest financial crisis in living memory, policy-makers have done well to avoid the worst of all outcomes, the descent into a Great Depression Mark II. It's all too easy to forget how bad the original version was: US GDP down 30 per cent from peak to trough and male unemployment up to 25 per cent of the American workforce. The numbers on this occasion are nothing like as bad. That's good news. But many people have gone further, suggesting not only that we've avoided a Great Depression Mark II but that we have also avoided the stagnation that was experienced by Japan over the last 20 years.

Unfortunately, this is a little less obvious. One of the overriding features of Japan's experience has been the persistence of very low interest rates. Even when they did go up, they immediately had to go back down again, suggesting the Bank of Japan has been using the Grand Old Duke of York approach to monetary policy.

And the reason why interest rates couldn't rise was exactly as it is in the West today: the Japanese were busily paying off their debts and were not prepared to borrow more at any interest rate. Indeed, the only sector of the economy that did borrow was the government. So public debt went through the roof. Sounds familiar?

But if we are suffering from a variant of Japan's debt difficulties, why has inflation been so high? To be fair, high inflation is mostly a UK phenomenon: it's nothing like as elevated either in the US or through much of Europe.

The difference is partly explained by sterling's earlier weakness and by big increases in VAT that will ultimately subtract from growth rather than persistently add to inflation. Nevertheless, inflation in the Western world has been higher than expected given the ongoing weakness of economic activity. The answer lies with the strength of oil, food and metals prices relating not just to the upheavals in the Middle East and North Africa – which certainly have provided an extra boost to oil prices – but also to the impact of strong growth in the emerging world more broadly.

That strength, in turn, is linked to monetary conditions in China and other emerging nations which still link the value of their currencies to the US dollar. They use "second hand" versions of US monetary policy. When the Federal Reserve sets monetary policy for the US economy, it is also defining monetary conditions for many parts of the emerging world too.

These countries mostly don't have the West's debt difficulties. Offer them low interest rates and their economies boom. Demand for commodities surges. Commodity prices soar. For the Western world, food and energy inflation goes up. With weak labour markets, higher prices rise are not matched by higher wages. That means we're all facing real wage cuts. And wage cuts imply lower growth.

Lots of people happily talk about a Plan B, as if it's possible to simply wave a magic wand to get us all out of this mess. But until they come up with a solution to the ongoing Japan-style difficulties associated with high debt and low incomes, their magic wands will remain as limp as their ideas. Dreams are all well and good, but every so often it's useful to take a dose of reality.