Not as Good as They Look

For most economic analysts, the past is the present. It is a popular sport to find historical parallels with the current period, and the strong consensus now is that 2010 has 2004 written all over it.

After all, 2004 also was the second year of a global economic recovery. The Chinese economy was also overheating, and authorities there were tightening monetary policy. Following a volatile first half, the year ended up being relatively benign for financial markets as fears of inflation subsided in China and the global economic recovery rolled on uninterrupted. Analysts expect 2010 to unfold in a similar manner.

But history repeats itself only for those who don't know the details. The global economy was on much stronger footing in 2004 to withstand any Chinese tightening. Economic growth across the world averaged 5 percent that year, with the developed world fully participating in the recovery process. This time around, the global recovery is far more uneven and the annual pace of expansion is slower, at just under 3.5 percent. What's more, while a boom in exports to the West helped China maintain a 9 percent growth rate back in 2004 even as its domestic economy slowed, it can hardly expect a similar contribution from the developed world this year. Indeed, developing economies led by China are now themselves the main engines of the world's economy. In order to keep the global economic momentum going, they need to steam ahead at a pace similar to the 7 percent that they averaged during the 2003–07 boom period.

The fundamental obstacle to achieving that is inflation. It has resurfaced much too quickly in many emerging markets, especially given the ample spare capacity in the world. Commodity prices have flared up to levels far above what can be justified by any increase in underlying demand. Food and energy prices, which typically account for a third of the consumer's basket in developing countries, are already back at 2007 levels. Not only do higher commodity prices boost headline inflation, they usually also pass through to other items over time in developing economies. By mid-2010, both headline and core inflation in most emerging markets should touch levels similar to those of 2006—the fourth year of the emerging-market boom and the third of a strong global economic recovery.

Why have commodity prices climbed so far and so fast in only the second year of a subpar global recovery? The lazy explanation strewn about by several market analysts has to do with runaway Chinese demand. Facts do not bear this out, however. While Chinese demand has undoubtedly been strong, inventories for almost all commodities, from aluminum to oil, are at multidecade highs, as global demand remains weak.

A better explanation for the irrational exuberance in the commodity pits is that interest rates remain so low across the world. Financial investors spurred on by cheap money and eager to acquire hard assets after the crisis poured more than $50 billion into commodity funds in 2009—more than three times the average sum in the 2003–07 boom years. This link is evidenced by the fact that in recent weeks commodity prices knee-jerked lower at the first signs of tightening by emerging-market central banks such as China's. In 2004 too, Chinese tightening took the wind out of any buildup in commodity-price inflation, although at the cost of a domestic economic slowdown for a few quarters.

All this suggests the global recovery is precarious. It is weaker than in 2004, yet inflation is already reaching the upper limit of the tolerance band in many emerging markets, and the speculative juices are continuing to flow freely in the commodity markets. This means that central banks will have to tighten monetary policy aggressively in the months ahead to keep inflation in check. That could, in turn, derail the fragile global healing process.

Unless the link between a tentative recovery and unjustifiably high commodity prices is somehow broken, 2004 and 2010 will have little in common. The current year may instead turn to be more like one in the late 1930s or in the mid-1970s—a sharp rebound, after which both the global economy and the world's stock markets struggled, making little progress through all the slush left over in the system after the big storm.