The concern about inflation would swiftly disappear if the US plunged into a deep receccsion, as investors increasingly fear. But for now, the dilemma is all too real. In October consumer prices rose at an annual rate of 3.5 per cent in the US, 2.1 per cent in the UK and 2.6 per cent in the eurozone – where November showed a jump to 3 per cent. German inflation is at its highest in more than a decade.

Prices are also gaining at an annual rate of 6.5 per cent in China, with rapid increases in other emerging markets too. The culprit everywhere: rising food and energy costs, underpinned by surging demand from those fast-growing developing countries.

China, India and other emerging nations are at a stage in their development where they have an enormous appetite for resources – oil and metals to fuel industrialisation and urbanisation, meat and milk for changing diets – and they are growing at a blistering pace. China’s economy is expected to expand by about 10 per cent next year and India’s by 8 per cent, in spite of the credit squeeze.

Energy prices have been surging for several years. But the take-off in food prices is more recent, accelerating over the past year with rising milk and dairy prices in Europe, more expensive beef in the US and soaring pork prices in China. Many economists believe the two phenomena are now interacting with each other, as high oil prices prompt farmers to set aside land for the production of biofuels, reducing the amount available for food production.

An intense debate is under way in central banks across the world as to whether the recent rapid rise in food and energy prices will continue – and what, if anything, they should do about it.

“We are seeing structural change in the historical commodity price relationships and that may imply structural changes in the relationship between headline inflation and core consumer prices,” says Ken Rogoff, a professor at Harvard and former chief economist at the International Monetary Fund. Headline inflation includes food and energy; core measures do not.

If Prof Rogoff is right, central banks may no longer be able to assume that rises in food and energy prices are short-term and that overall inflation will quickly revert to the core rate. Instead, they have to factor in the possibility that food and energy price increases will remain high for years. This would mean that to achieve a given level of overall inflation, authorities would have to show less tolerance for rises in the price of other items.

The US Federal Reserve believes that food and energy price inflation will slow over the next couple of years to no more than the general rate of inflation. This is why most Fed officials continue to talk about core inflation as representing the underlying rate of price increases and do not think it will be necessary to keep inflation for other items much below the target rate.

Yet inside the Fed there is an active debate on the subject. In a recent speech, Richard Fisher, president of the Dallas Fed, warned that rising food and energy prices “might be providing signals of longer-term structural inflationary pressures”.

That view is shared by many officials in other central banks, who think food and energy prices may continue to rise at a faster rate than other prices for years to come. Outside the US, most central banks – including the European Central Bank – emphasise the headline rate of inflation that includes food and energy. They tend to be more sceptical about the notion that moderate core inflation measures give a good indication of future inflation trends.

If the Fed view of the world is correct, these central banks may be taking too pessimistic a stance on future price trends and setting policy too tight. But if the Fed view is wrong, it may itself be setting policy too loose.

Regardless of their differences, all central bankers worry that the longer food and energy prices keep pushing up overall inflation, the greater the chance that the expectation of higher inflation could seep into daily decision-making by individuals and businesses, shifting up the general rate of price increases for all goods and services.

“Central banks have earned enormous respectability and credibility, but they need to keep it,” says Jim O’Neil, chief economist at Goldman Sachs. “In the grand scheme of things, this decade could still turn out to be like the 1970s.”

The danger that high food and energy prices could feed through into general price dynamics is heightened by the less-than-stellar record of the world’s central banks in keeping inflation under tight control in the recent past.

Consumer price inflation exceeded its actual or implicit target in many of the world’s most important economies in 2006 – including the US (3.3 per cent) the eurozone (2.2 per cent) and the UK (2.3 per cent) – and in many emerging economies, including India. Only Japan, which remains stuck on the brink of mild deflation for largely domestic reasons, is truly free from upward price concerns.

Central bankers worry that high rates of factory use and low unemployment around the world after years of rapid growth make it more likely that higher food and energy costs could feed through into broader wage and price pressures.

David Hensley, an economist at JPMorgan, says measures of global capacity utilisation are at or near “their highest levels in more than a decade”, while global interest rates are only approaching their historic average levels in real terms. In other words, in the past when capacity was this tight, central banks felt the need to run a much tighter monetary policy to stop inflation getting out of control.

Monetary policy is based on what is likely to happen to the economy in the future, rather than what is happening today. So the key question is how much effect the credit crisis will have on growth globally and in each of the individual economic areas.

If growth slows very sharply in any or all of the main economies, unemployment will rise and capacity utilisation will fall, making it less likely that inflation will stay high or move higher. At this juncture, the challenge for policymakers looks different in industrialised countries and emerging markets.

The emerging markets – which have largely escaped the initial impact of the credit squeeze – have to worry primarily about inflation. This could change if the US and other developed markets suffer a very sharp slowdown. But for now, says Stephen King, chief economist at HSBC, “people in the emerging world are entirely concerned about inflation, overheating and monetary excess”.

The biggest problem for these economies is that their monetary and exchange rate policies make it difficult to manage the inflation risk. For the industrialised economies of the US and Europe – exposed to the direct impact of the credit squeeze – the threat is more complex. Policymakers have to judge the extent to which they can risk easing interest rates to offset the impact of the credit squeeze on growth when inflation is still high. This is necessarily a difficult judgment, because no one knows how great the impact of the credit crisis on growth will be.

Investors increasingly fear a recession in the US. In all likelihood, that would put paid to its inflation concerns. But the Fed’s base case scenario is still that growth recovers next year and unemployment rises just a little, creating only a modest amount of slack in the economy.

There is a lot of uncertainty about the impact of a feared pull-back in lending in the UK and the eurozone too. So policymakers do not have a good sense of how much spare capacity will open up. Life would be much easier for them if they did not have to worry about high food and energy prices. But they do.

“It is the revenge of the emerging markets,” says one prominent economist. “They are running red hot, keeping the oil price tight. This sustains inflation pressure and makes it much harder for the Fed to cut interest rates.”

The risk of an adverse outcome globally is heightened by the weakness of the dollar and the monetary chains that bind most emerging markets to the US via currency pegs. Since the start of the credit crisis, the dollar has plunged in value against other freely floating currencies, pushing up the price of oil and other commodities denominated in dollars but purchased by buyers all over the world.

The Fed worries that if it cuts interest rates too aggressively, it could weaken the dollar further, pushing up oil and with it US inflation. Most emerging markets, meanwhile, have intervened to ensure that their currencies decline roughly in tandem with the dollar, adding a further stimulus to already fast growth and raising the risk of overheating. By tying their currencies to the dollar, these economies are importing US monetary policy and have only limited ability to offset it.

“US policy is made for domestic conditions,” says Vincent Reinhart, a fellow at the American Enterprise Institute and former chief monetary economist at the Fed. “The inflation risk at the global level is that there will be many economies that will have inappropriately easy policies because they have taken the decision to keep their exchange rate vis-à-vis the dollar stable.”

(to be continued)