Fears of 1970s-style stagflation are back in the air. Global bond markets are growing ever more nervous over this possibility, and US and European central bankers are talking increasingly tough about the perils of mounting inflation.

Yet today’s stagflation risks are very different from those that wreaked such havoc 35 years ago. Unlike in that earlier period, wages in the developed economies have been delinked from prices. That all but eliminates the automatic indexation features of the once dreaded wage-price spiral – perhaps the most insidious feature of the “great inflation” of the 1970s. Moreover, as the stunning surge of the US unemployment rate in May suggests, slowing economic growth in the industrial economies is likely to open up further slack in labour markets, thereby putting downward cyclical pressure on wages over the next couple of years.

But there is a new threat to global inflation that was not present in the 1970s. It is arising from the developing world, especially in Asia, where price pressures are lurching out of control. For developing Asia as a whole, consumer price index inflation hit 7.5 per cent in April 2008, close to a 9½-year high and more than double the 3.6 per cent pace of a year ago. Sure, a good portion of the recent acceleration in pricing is a result of food and energy – critically important components of household budgets in poorer countries and yet items that many analysts mistakenly remove to get a cleaner read on underlying inflation. But even the residual, or “core”, inflation rate in developing Asia surged to 3.8 per cent in April, more than double the 1.8 per cent pace of a year ago.

Given Asia’s new-found role as the world’s producer, such an outbreak of surging inflation in this region is not without serious risks to the global economy. The globalisation of trade flows is a new transmission mechanism of worldwide inflation that was not evident in the 1970s. According to estimates from the International Monetary Fund, overall exports should hit a record 32.5 per cent of world gross domestic product in 2008, more than 50 per cent above the export share of 21 per cent prevailing in 1980, when the “great inflation” was nearing its peak.

At the margin, that means cost pressures and price determination today are shaped much more in the global arena than they were during the domestically driven stagflation of the past. Asia’s outbreak of surging inflation is especially problematic in that regard. Nowhere is that more evident than in China – the new engine of Asian output and exports.

Chinese inflation has surged at an 8.3 per cent average annual rate over the four months ending May 2008, the sharpest sustained increase on a year-on-year basis since the mid 1990s. China’s inflation problem is much deeper than the food and energy price shocks that thus far have played a disproportionate role in driving its consumer price index higher. Also at work are serious wage pressures reflecting, in part, increases in minimum wages associated with new labour reform laws. Meanwhile the People’s Bank of China has held its policy lending rate below headline inflation, resulting in negative real short-term interest rates.

The result has been an ominous increase in Chinese inflationary expectations, strikingly reminiscent of similar occurrences that plagued the developed world in the 1970s and early 1980s. History does not treat kindly a serious deterioration in inflationary expectations. The longer such a trend persists, the more wrenching the monetary tightening required to arrest it – and the greater the risk of a subsequent hard landing. That is the last thing China wants or needs.

China is hardly alone in its reluctance to take firm action against a worrying build-up of inflationary pressures. That is true throughout most of developing Asia, where hyper-growth is viewed as the panacea for the aspirations of a growing middle class. Throughout the region, central banks are keeping short-term interest rates far too low to combat these inflationary pressures. For developing Asia as a whole, a GDP-weighted average of policy rates is currently about 6.75 per cent, fully three-quarters of a percentage point below the 7.5 per cent headline inflation rate.

Such monetary accommodation in an increasingly inflation-prone developing Asia spells a persistence of elevated price pressures in this vital segment of the global production chain. Not only does that threaten living standards for newly prosperous households in the developing world; it also takes an especially severe toll on those at the lower end of the income distribution. And, of course, it provides a price shock to imported goods in the developed world, which now play a much greater role in meeting the demands of domestic consumption.

Notwithstanding recent pressures in bond markets, the world remains largely in denial over the outbreak of a new strain of stagflation. The hopes of “core inflationists” depend on a reversion in food and energy prices to take headline inflation lower in the developing world. Yet this will be the sixth year in a row when that has not happened. The “market purists” are counting on currency adjustments – especially sharp appreciation of currencies in developing Asia – to temper the transmission of price pressures from these export-led economies. Yet these are not economies that want to use the currency lever to put their growth imperatives at risk.

The risks of a new stagflation are mounting. But it will not be a replay of the 1970s. Like nearly everything else in the world these days, this one is likely to be made in Asia.

The writer is chairman of Morgan Stanley Asia

Until six months ago, most Asian countries could boast of strong growth and moderate inflation. It was a record the rest of the world looked on with a mixture of respect and envy.

The main concern across the region was how the credit crisis on both sides of the North Atlantic would hurt Asia's export-driven economies. The expectation was that the effects of a US and European slowdown would be mitigated by growing demand within Asia and, in any case, that weakening demand elsewhere would keep the lid on price pressures.

When Indonesia cut interest rates last December, for example, policymakers were clear about where they thought the dangers lay. "We don't have to worry as the government has taken steps to contain inflation," said Hartadi Sarwono, deputy governor of the central bank.

But those calculations have been thrown off course. Inflation, not lower US consumer demand, has proved to be the biggest external shock for Asian economies. With inflation's relentless rise has come the fear that Asian governments lack the ability - and more importantly the political will - to stop higher domestic and imported prices from devastating their economies.

The dangers are difficult to overstate. They range from political turmoil - as basic goods are priced out of reach of Asia's poorest people - to the possibility of a new economic bust, as authorities are forced belatedly to take radical measures to curb persistent inflation.

At the heart of the dilemma for Asian governments is a basic contradiction. Economists and western policymakers know that the modern way to beat inflationary pressures is to engineer slower growth and thus a degree of economic insecurity, so companies and employees think twice about bidding up prices and wages. But the bedrock of support for Asian administrations, the region's governments believe, has been the rapid growth that has over the past decade brought living standards steadily closer to the levels enjoyed in Europe and North America.

China, which has been a net oil importer since 1994, last week reported a fall in consumer price inflation. But that was the one small piece of good news on prices in the region for months. For developing Asia as a whole, consumer price inflation hit 7.5 per cent in April, close to a 9½-year high and more than double the 3.6 per cent pace of a year ago. Between April and May, for instance, Pakistan's annual inflation rate rose from 17.2 per cent to 19.3 per cent. Mercer, the consultancy, forecast last week that Indian salaries would rise by 15 per cent a year until 2011 amid skills shortages.

Even in China, higher underlying inflation remains an "ongoing concern", according to Jing Ulrich, chairman of China Equities at JPMorgan, as input costs continue to rise and the gap between government-regulated energy prices and world prices widens.

Asia's inflation troubles are not taking place in a vacuum. From Washington to Frankfurt, central bankers in the developed world are banging the drum on rising prices. Leading emerging markets have followed suit: the Brazilian central bank has been increasing interest rates since April, while the Turkish central bank recently almost doubled its 2009 inflation target.

While the proximate causes of higher inflation are the same the world over - soaring energy and food prices - Asia is special in two respects. First, unlike the advanced economies that receive its manufactured goods exports, many Asian economies are more vulnerable to food price rises because basic nutrition accounts for large shares of domestic expenditure. Food makes up 14 per cent of the consumer price inflation measure in South Korea but its weight is 33 per cent in China and 57 per cent in India.

Second, the balance of economic opinion suggests that Asian countries are now paying the price for years of unsustainable exchange rates and monetary policies. After the Asian financial crisis of 1997-98, most countries in the region dedicated considerable effort, at least initially, to low and stable exchange rates to promote investment and growth.

A standard economic theory dating back to work by Robert Mundell, a Nobel prize-winning economist, suggests an "impossible trinity" in economic policy. No country can simultaneously have freely flowing capital and control of both the exchange rate and monetary policy. Only two of these three are possible, he proved. Moreover, since it is very difficult to control the flow of capital in Asian-style open economies that specialise in trade and welcome foreign investment, the choice is generally between controlling domestic monetary conditions or exchange rate stability.

Although such countries as China manage their exchange rates closely, they have difficulty running an independent monetary policy. To "sterilise" the injection of cash into the economy caused by big trade surpluses, they sell bonds to the banking system, taking some of that cash out of circulation. Yet such policies are never foolproof.

Evidence that Asia has been attempting to make the "impossible trinity" possible abounds, whether it is the rise in core inflation, the enormous rise in foreign exchange reserves or the continued low exchange rates and high trade surpluses in the region. "It is remarkable," Hervé Hannoun, deputy general manager of the Bank for International Settlements, argued in a paper last year, "that the real exchange rate of most Asian countries has on balance depreciated over the past 10 to 15 years."

But as the Federal Reserve has slashed US interest rates, the tensions in the trinity have increased. Low US rates raise the attractiveness of capital flows to Asia, putting upward pressure on exchange rates. The result has been that Asian central bankers - often with an eye on not exacerbating currency tensions - have been less than aggressive in dealing with inflation. In effect, they have imported loose monetary conditions from the US.

Real interest rates - the nominal interest rate minus the rate of inflation - are already negative by an average 1.7 per cent in Asia excluding Japan, according to UBS, well below the level both before and after the Asian financial crisis of a decade ago. Inflation is also accelerating rapidly for energy-importing countries as oil continues its ascent towards $140 a barrel. Duncan Woolbridge, economist at UBS, warns that "failure to tighten should mean that the current cost-push inflation will transform into a persistent inflation".

The muted monetary policy response is understandable given Asia's success over the past decade and its attachment to stable exchange rates. But the consequent rise in inflation - a problem in itself that will need addressing - also carries with it serious budgetary and political problems.

On the fiscal side, energy subsidies are straining treasuries, as Asia's oil production has fallen to one-third of its imports. Beijing might have the fiscal resources to avoid any emergency cut in fuel subsidies - as well as the political will not to risk social unrest in the run-up to August's Olympic Games. But deep coffers, in terms of fiscal balances, stop at the Chinese border. Seven Asian finance ministries have raised retail fuel prices in the past month, with Malaysia taking arguably the bravest step by imposing a 40 per cent increase.

Politicians are not escaping the fallout. Lee Myung-bak, South Korea's embattled president, last week likened the "resources crisis" to the 1970s oil price spike and the 1997 Asian financial crisis. In Malaysia, the ruling coalition emerged bruised from elections this year that underlined serious ethnic tensions. Governments in India and Indonesia are preparing in the coming year to face voters who are particularly sensitive to inflation. As well as lifting rates, both have recently resorted to symbolic gestures such as calling on ministers to cut down on travel to save fuel.

Elsewhere, violence is breaking out in Pakistan and Sri Lanka, both of which are struggling with inflation of about 20 per cent. In Nepal, street protests over fuel have coincided with an attempt by the Maoist party to form a coalition government.

By reducing fuel subsidies, Asian governments are heeding international advice to pass on to consumers the real cost of energy and food, and thus curb demand. But such policies are difficult, especially in countries that do not have extensive social security systems to compensate the poor and have used price controls as an alternative. Central banks in the region are raising interest rates, although not as fast as prices are rising.

For central bankers, any mismanagement of inflation could erode much of the credibility that they have regained since the 1997 Asian financial crisis. Ifzal Ali, chief economist at the Asian Development Bank, says: "Suppressed inflation resulting from unsustainable implicit and explicit subsidies is out of the bottle and there is an imperative to deal with that.

"Most central banks and governments know the trade-offs very well and know what is the right thing to do," he adds. "The problem is that the political price for absorbing short-term pain is very high."

But with the impossible trinity, there is no easy option. Indeed, one of the consequences of rising inflation in Asia is to undermine the rationale for exchange rate stability. The price of Asian goods is going up and that has exactly the same effect on Asian economies and export prospects as a rise in the exchange rate.

So the risk for Asia is that it is entering the period just before the next bust. Persistent inflation, tolerated to maintain rapidly rising living standards but without an adequate policy response, may lead to much tougher measures later, resulting in just the economic instability the region has tried to avoid over the past decade.

Communist Vietnam has been raising rates aggressively - by two percentage points last week to 14 per cent, the highest level in Asia - but with inflation already running at 25 per cent, Vietnam's failure to control its growth means that it is now "bearing the classic capital-flight consequence of an inappropriate policy mix", says Glenn Maguire, Asia chief economist at Société Générale.

For the rest of the world the potential outcomes are just as worrying. While trade imbalances would narrow in a world of high Asian inflation that reduced the region's competitiveness, that would also add to the price pressures in the US and Europe, adding to the squeeze on real income levels under way.

That is why the warnings are being heard ever louder. As Stephen Roach, chairman of Morgan Stanley Asia, wrote in the Financial Times last week, the risk is a new global stagflation - the combination of economic stagnation with high inflation - and one that is "made in Asia".

'Three to four officers in a single car'

In Mumbai, it is common to see convoys of up to 20 cars bristling with armed police ferrying high-ranking officials through the chaotic traffic, blocking off other motorists and making the city's gridlocked roads even worse.

In the past few years, with India's economy growing at an annual 9 per cent, the citizens of its bustling financial capital have been too busy to worry about such excesses on the part of their politicians.

But with soaring fuel prices threatening to drive inflation to levels not seen in more than a decade, this tolerance has evaporated. In a country where issues as basic as a surge in the price of onions have been known to unseat governments, politicians are taking note.

"Reduce fuel bill by 5 per cent. Avoid unnecessary meetings and travel. Three to four officers should use a single car," R.R. Patil, the deputy chief minister of Maharashtra, the state that contains Mumbai, barked at government officials in a recent meeting on car pooling.

Such measures are little more than symbolic. But government officials across India are at a loss for what else to do in the face of sharp movements in global commodity prices that are beyond their control and are pushing up inflation.

The central government, in particular, is panicking. The United Progressive Alliance, India's ruling coalition led by the Congress party, must call an election by next May and has already suffered several heavy losses in state polls, with inflation emerging as the number one issue.

In the 12 months to May, India's inflation rate reached 8.75 per cent, its highest level in seven years and up from just 4.5 per cent in January.

With world crude prices leaping above $130 a barrel, the government this month felt obliged to increase retail fuel prices by an average of about 10 per cent. That was in order to stem losses from subsidies that are costing the equivalent of more than 3 per cent of gross domestic product.

Although fuel subsidies mean the government is still charging consumers an effective rate of barely $50 a barrel, the price rise is expected to add another percentage point to inflation. That would bring inflation this month to a level not seen since the mid-1990s and many think it will then climb further, into double digits.

The economy is still growing strongly but there are signs that this too could soon come under pressure. The Reserve Bank of India, the country's central bank, having tried to bring inflation under control through indirect means such as increasing the amount of cash that banks must keep in reserve, this month finally resorted to an increase in interest rates.

It lifted its key "repo" lending rate by 25 basis points to 8 per cent, its highest in more than five years, and economists foresee more rises to come. "Policymakers now are more concerned about inflation - inflation first, then growth," says Shuchita Mehta, economist with Standard Chartered Bank in Mumbai.

Despite the central bank's efforts, however, inflation is already a fact of life for India's millions of poor and lower middle-class people.

Sangeeta Khanna, a mother shopping for groceries in Colaba market in south Mumbai, says the price of vegetables on average has risen from Rs15 ($0.35, £0.18, €0.23) a kilogram a few months ago to Rs25 now. The price of dhal, that staple of Indian dinner tables, is up by about 15 per cent while chicken is up by around 42 per cent. "The government should do something about it - what can we do?" she asks.

At a nearby vegetable store, fishermen's wives complain that the price of lower grades of rice is up by 66 per cent. "Only once the whole public stands up and says something, only then will something happen," says one of the women, Latika Raghunath Koli, gesticulating angrily as a curious goat wanders over to see what the fuss is about.

Ms Koli says her household, which she shares not only with her husband but with two other couples and five children, has to spend Rs15,000 a month on essential items - a lot for people whose incomes are not only generally low but also depend on the vagaries of fishing.

At Colaba Sudam Nagari a few blocks away, one of Mumbai's many fishing villages that jut out from the city's shores on to the Arabian Sea, Bhaskar Tandal is up to his elbows in grease reconditioning the two-cylinder engine of his fishing boat. The fuel price increase is costing him an extra Rs60 a day - a significant amount considering he catches as little as Rs200 worth of fish on an "unlucky" day and Rs2,000 on the best days.

"Our profit margins are narrowing day by day," he says.

Yet Mr Tandal shows an awareness of the wider factors behind the surge in inflation. Educated about global oil prices by watching the plethora of cable news channels that have launched during India's economic boom, he asks philosophically: "What can the government do? Everyone in the world is affected: we are not the only ones."

China announced fresh monetary tightening measures on Monday after inflation data showed price rises of 8.5 per cent in April, the second highest monthly figure for 12 years.

The People’s Bank of China lifted the share of funds that commercial banks must leave on deposit with the central bank by 50 basis points to 16.5 per cent, the fourth such increase this year.

The directive will freeze about Rmb200bn ($43bn, €28bn, £22bn) in the financial system, in line with “the central bank’s intention to absorb excessive domestic liquidity from the rapid increase in forex reserves,” said JPMorgan.

While Beijing is maintaining an official monetary tightening bias, it appears to have suspended the appreciation of the Chinese currency – regarded by economists as another key instrument for fighting inflation.

The renminbi has stalled in recent weeks against the dollar, after appreciating at an annualised rate of nearly 20 per cent in the first quarter of this year.

Beijing-based economists and government officials, speaking on condition of anonymity, said the PBoC, long known as a supporter of faster currency appreciation, was now being blocked by other ministries.

They said that the slowing rate of the growth of China’s exports had prompted a number of ministries to press for a pause in renminbi appreciation, in order to minimise the impact of the currency on export industries and employment.

“The government departments are backtracking because of the slowdown in net exports,” said one ­economist.

China recorded a trade surplus of $16.7bn in April but the rate of growth of imports outpaced exports, as it has nearly every month since last October.

The PBoC has generally argued that currency appreciation is essential to stemming the growth of the trade surplus and the unchecked flow of speculative funds into China.

Rising food prices continue to be the largest contributor to inflation, with year-on-year price increases in this sector hitting 22.1 per cent in April, compared with 21.4 per cent in March.

But economists say the underlying driver of inflation is the excess demand created by the huge flow of funds into China through the trade surplus and other avenues, as well as the velocity at which money circulates in the economy.

Beijing’s efforts to talk down inflation by issuing headline-grabbing edicts that threaten price controls and other administrative measures do not seem to have borne fruit so far.

“As underlying inflationary pressures remain undiminished, it is vital for the government to keep its tightening policy stance to anchor inflationary expectations,” Goldman Sachs said in a research note.

Wang Qing, of Morgan Stanley, said headline inflation had already peaked even though April figures were above market expectations.

“The visible slowdown in export growth in recent months is serving to cool the economy, reducing the need for further harsh macro-measures,” he said.

Hank Paulson, the US Treasury secretary, may receive what his hosts consider a nice gift when he arrives in Beijing early on Wednesday – a strengthening Chinese currency poised to reach a significant new high.

The renminbi closed trading in China on Friday at Rmb7.017 to the dollar, on the verge of breaking through Rmb7.00, a symbolic moment following a period of accelerated appreciation since late October.

After years of arm twisting by Washington, where the currency has become a litmus test of Chinese responsiveness to US complaints on trade, Beijing expects Mr Paulson to acknowledge publicly the renminbi’s gains.

But the bilateral prism through which Washington sees the issue gives a distorted picture of the reasons for the renminbi’s strengthening, say analysts, and also exaggerates the real changes in the currency’s value. “A small factor is the pressure from the US. A big factor is inflationary pressure in China,” said Gao Shanwen, an economist with Essence Securities in Beijing.

With inflation hitting a 12-year monthly high of 8.7 per cent in February, after several months of sharply higher food price rises, the currency has moved to centre stage as a policy instrument for Beijing.

The top ranks of the government have long been split on the need for the currency to rise more quickly, with objections from the economic planning ministry and the export lobby enough to keep the pace slow.

Wen Jiabao, the premier, has been ineffective in wresting the issue out of the bureaucratic morass it has long been caught in, preferring instead to wait until a consensus was forged on the issue, say local economists.

But while at the top of the US agenda, the currency has in some respects remained a second order issue for a Chinese government focused above all on maintaining fast economic growth. For Beijing, a fast-growing economy helps in turn address a range of difficult issues – the rich-poor gap and the underfunded health, education and welfare systems. “Without economic growth, everything else becomes really problematic,” Michael Enright, a consultant, and co-author of a new book, China Into the Future, said.

But the spectre of inflation has now galvanised the government on the currency. After rising by about 14 per cent over 30 months since mid-2005, when the US dollar peg was dropped, the renminbi has accelerated at an annualised pace of about 15-20 per cent against the US currency in the opening months of 2008.

A stronger Chinese currency helps reduce the cost of importing products such as soybeans, 80 per cent of which are used in pig feed. Chinese inflation has primarily been driven by higher food prices, especially of pork, the staple meat. The currency also remains helpful in taking the steam out of the swollen trade surplus, which has been a political problem in relations with big trading partners.

Incentives for policymakers to allow the currency to appreciate could be short-term, amid signs that headline inflation could fall from mid-year and that the trade surplus is peaking.

“I expect the pace of appreciation to slow in the second half of the year,” said Ha Jiming, of China International Capital, the country’s largest investment bank, as inflation and the surplus eased.

But while Mr Paulson may give China credit for lifting the renminbi against the dollar, China’s other trading partners have less reason to applaud. Europe, now China’s largest trading partner and increasingly anxious about the size of the bilateral deficit, has seen the euro appreciate by more than 3 per cent this year against the Chinese unit. The Japanese yen, in turn, had strengthened by more than 7 per cent in 2008 by the end of last week.

As a result, the renminbi’s effective exchange rate, the yardstick advocated by bodies such as the IMF, has not moved at all this year against its leading trading partners.

Such outcomes are hardening suspicions in Europe and elsewhere that the renminbi is still tracking the dollar. As long as the currency is rising against the greenback, however, Mr Paulson might consider that to be Brussels’ and Tokyo’s problem.

A small detail in Anta Sports’ listing prospectus last July has yielded an unexpected headache for the Chinese sportswear company as the value of the renminbi rises.

The seemingly innocuous sentence declared that money raised by Anta from its Hong Kong initial public offering, but not immediately used, would be deposited into “interest-bearing bank accounts ... in Hong Kong”.

Most other Chinese companies have been less specific about where their unused IPO proceeds go.

But because of its specificity, Anta found its cash trapped in Hong Kong dollars as the renminbi rose by 7 per cent against the territory’s currency, which is pegged to the US dollar. As the majority of its costs were in renminbi, this meant that the value of Anta’s cash pile was steadily being eroded.

In addition, while China’s central bank was raising interest rates to cool the country’s overheating economy, Hong Kong banks were busy cutting rates as they were forced to follow US interest rate movements because of the currency peg.

Anta’s problem illustrates the difficulties that the renminbi’s steady appreciation has caused for companies trying to use foreign currency to fund investments in mainland China and get around the country’s capital controls to do so.

Anta’s IPO came during a strong bull run in the Hong Kong stock market, and the heavily oversubscribed offering yielded HK$3.1bn (US$398m, €252m, £200m) in proceeds, just HK$714m of which the company had spent by the end of the year.

This February Anta decided to remedy matters and issued a statement to the stock exchange saying it would transfer its extra cash into renminbi accounts in mainland banks to achieve better returns.

Paul Ling, chief financial officer, told the Financial Times that the difference in interest rates given by mainland Chinese banks versus Hong Kong banks was 2-3 percentage points. “But no matter what the interest rate is, it is hard to compete with the [expected] 10 per cent increase in the value of the renminbi this year.”

China’s capital controls mean that individuals and companies are allowed to convert just HK$20,000 of cash a day into renminbi under normal circumstances. Mr Ling declined to say how much he was able to convert every month, but he described the way Anta, and probably other companies, were legally transferring far larger amounts than the daily limit into China – a sensitive subject few other companies would discuss.

Anta takes bills from its wholly owned Chinese subsidiaries – invoices for wages and raw materials, among other things – and presents them to the State Administration of Foreign Exchange (Safe). Safe then gives permission for Anta’s Hong Kong-listed entity to exchange the amount needed to pay the bills, even if it is more than the daily HK$20,000 limit.

Since the Chinese subsidiary no longer has costs to pay, Mr Ling can then direct it to place its renminbi-denominated revenues into mainland banks to take advantage of higher interest rates and rising currency value, thus replenishing Anta’s cash reserves on the balance sheet.