Stephen King: Central banks have more to fret about than a temporary pick-up in inflation

Workers who demand a big pay increase are likely to find themselves swiftly outsourced, offshored or replaced by migrant workers

Sometimes monetary policy is easy. Sometimes it's difficult. At the moment, it's probably the latter. Policymakers at central banks like things to be unambiguous. If growth is strong and inflation is rising, it's fairly obvious that interest rates should go up. If growth is weak and inflation is falling, it's equally obvious that interest rates should come down. What, though, of the more difficult combinations? What should central banks do when growth is strong but inflation is falling? Or when growth is slowing but inflation is rising?

Sometimes monetary policy is easy. Sometimes it's difficult. At the moment, it's probably the latter. Policymakers at central banks like things to be unambiguous. If growth is strong and inflation is rising, it's fairly obvious that interest rates should go up. If growth is weak and inflation is falling, it's equally obvious that interest rates should come down. What, though, of the more difficult combinations? What should central banks do when growth is strong but inflation is falling? Or when growth is slowing but inflation is rising?

These are not idle academic questions. They are, instead, the questions that central bankers are asking of each other now. Most of the recent manufacturing surveys - whether from the US or from Europe - have pointed to slower growth. Yet inflation - at least in the US - seems to be on the rise. So what should central banks do? Cut interest rates because growth is fading? Or raise interest rates because inflation is going up?

For the Federal Reserve, the answer so far has been to raise interest rates. Then again, rates were so low in the first place that Alan Greenspan and his friends on the Federal Open Markets Committee can easily argue that, after tightening monetary conditions yet another notch, the level of interest rates still seems to be rather supportive by past standards.

For other countries, the dilemma is, perhaps, a little less pressing: the strength of both sterling and the euro has probably kept inflation at bay across Europe to a greater extent than in the US, suggesting that the bigger concern on this side of the Atlantic may prove to be a lack of growth rather than a resurgence of inflationary pressures.

Nevertheless, there's no doubt that policymakers are feeling a little twitchy at the moment. Take, for example, the communiqué released by the Federal Reserve after last week's policy meeting. "Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices ... Pressures on inflation have picked up in recent months and pricing power is more evident." Hmm. For all the Fed's attempts to encourage greater transparency and predictability, this isn't the kind of statement that tells us that the Fed knows exactly what it's doing. All the Fed seems to be telling us is that the plot has thickened.

Part of the problem lies in assessing the sustainability both of the growth slowdown and of the inflationary pick-up. We've had growth pauses before, but they haven't amounted to very much. Equally, though, we've seen the occasional rise in headline inflation without any accompanying rise in inflationary expectations. So what's the right approach to monetary policy in these confusing circumstances?

The good news is that the Federal Reserve (and, for that matter, other central banks) probably has time on its side. US Treasury yields, at around 4.3 per cent, are a good 1 per cent lower than expected a year or so ago, suggesting that financial markets do not see inflation as a major long-term problem. So long as yields don't rise too far - and by that, I mean a rise towards 5 per cent or beyond, a rate we've yet to see in this economic cycle - the Federal Reserve can take comfort from the belief within financial markets that its credibility is not in any serious doubt. That means sticking to the "measured" pace of rate increases, a quarter point or so at each of the forthcoming policy meetings.

Another inflationary concern for central banks is likely to be wages. Higher headline inflation will occur from time to time, in part because central banks can't - indeed, shouldn't - control for each and every little exchange rate or commodity price movement that takes inflation away from the "chosen path". If, however, wages start to rise in response, central bankers are likely to become a lot more concerned: it's when the rise in inflation starts to infect people's confidence in ongoing price stability that central bankers are probably getting things wrong.

The good news, to date, is that wage increases have been relatively restrained. There's been a little bit of upward pressure on wages in the US on some measures, but the evidence is hardly overwhelming. In the UK, wages have also risen, although with public spending growth likely to slow over the next year or so, I doubt that we're going to see an ongoing acceleration. As for the eurozone, there's very little evidence at all that wage growth is beginning to accelerate.

I suspect, though, that it's very difficult these days to generate the kind of wage-price spiral that led to high inflation and weak growth - known as stagflation - in the 1970s. Much of the inflation that we saw back then was a mixture of demand-pull pressures - the Barber boom in the early 1970s springs to mind - and cost-push pressures - unions who could monopolise the supply of workers and, therefore, demand stupidly high wage increases. Today, though, it's increasingly unlikely that wages will behave in this way.

Three things have changed. First, there's been a huge increase in the supply of actual and potential workers, reflecting China's and India's increasing integration into the world economy, together with the emergence of central and eastern Europe. Second, companies have become increasingly multinational, taking advantage of a huge increase in capital mobility to locate production where labour offers the best mix of price and productivity. The collapse in telecommunications costs has seen multinationals emerge not just in manufacturing but also, increasingly, in services as well. Third, changes in legislation have gradually reduced the unions' monopoly over labour supply.

Any increase in headline inflation that stems from, say, higher oil prices is not likely these days to be followed up by a serious acceleration in wage growth. Workers who demand a big pay increase by means of compensation are likely to find themselves swiftly outsourced, offshored or replaced by migrant workers from elsewhere. And, in the process, growth may begin to slow - explaining, perhaps, the Federal Reserve's latest dilemma.

The good news from all of this is that any pick-up in inflation is likely to be transitory. Without wage-price spirals, it's difficult to see how inflation really could accelerate in a meaningful way unless central bankers were to turn on the printing presses with manic ferocity. Even then, though, we'd probably never believe that they could be so stupid, thereby exposing the futility of their crazed plans.

The bad news is that central bankers may have to look at other indicators of economic health a little more closely. If inflation no longer moves around very much, do our central bankers have a serious job to do anymore? The weak argument in their favour is that, without them, inflation would be a lot more volatile, so their very existence is a useful insurance policy against future nasty surprises. The strong argument is that their true mandate goes beyond price stability, or at least beyond price stability as defined within most central bank mandates. Asset prices, balance sheets, debt levels - these are the key ingredients that make up modern macroeconomic problems. It's the price of capital, not the price of goods, services and labour, which is now the really big issue, and central banks will, I suspect, increasingly have to loosen their inhibitions and focus on this new, and significant, challenge.