July 15 (Bloomberg) -- Asia just can't seem to catch a break.

First, there was the fallout from the 1997-1998 crisis. Then Japan and China exported deflation around the region. And now, as consumer prices recover, Asia may be facing another threat: stagflation.

Sound like a reach? Not at all, says Andy Xie, Hong-Kong- based chief economist at Morgan Stanley Asia Ltd. ``While the economies are decelerating quickly, inflation rates are picking up virtually everywhere,'' he says. ``Should Asian central banks take stagflation seriously? We think so.''

The chances of 1970s-style stagflation, or something worse, are relatively small. But investors and policy makers who suffered through that period know any risk inflation will rise more than gross domestic product is too big to ignore. The trend could wreak simultaneous havoc in bond and stock markets.

One telltale risk is the low level of interest rates around Asia, which have created strong demand for property. The resulting distortion in the allocation of resources compounds over time, as we saw here in Indonesia during the Asian financial crisis. Easy money sent Jakarta's property values and stocks skyrocketing.

Other stagflation risks include rising wages around Asia and a major supply shock related to turmoil in the Middle East. Thanks to these trends, Xie says, the ``mild stagflation that we are currently experiencing could turn virulent.''

Accepting Inflation

If so, Asian central banks might be caught accommodating oil prices, as the U.S. Federal Reserve was in the 1970s. The resulting weakness in currencies may exacerbate the increases in inflation. Higher consumer prices and a falling currency might slam bond markets across the region.

The trouble is, Asian central banks seem poised to leave borrowing costs low, thereby accepting higher inflation. It's a trade-off monetary authorities sometimes make, especially when governments are relying on them to support growth. That's even though the Fed already has boosted U.S. rates for the first time since May 2000, giving Asian officials room to do so.

When it comes to stagflation risks, Xie is particularly concerned about China, South Korea and Taiwan. Korea and Taiwan, he opines, may not raise interest rates for another four to six quarters, as their monetary policies remain focused on slow growth. China may boost rates before the end of the year, but Xie thinks it will move half as much as the U.S.

Indonesia's Growth

Here in Indonesia, meanwhile, growth is running about 5 percent this year, while consumer prices may advance close to 7 percent. Indonesia has made remarkable progress cutting inflation from the days of the Asian crisis. But prices growing faster than GDP hurts living standards and this economy's ability to attract foreign investment.

Thanks to lots of money sloshing around the globe, including from easy Federal Reserve policies in Washington, China's inflation rate has accelerated to about 5 percent from the deflation of 2002. Korean inflation is running at about a 3.6 percent versus 3 percent a year ago. That's happening at a time when the Chinese economy is decelerating and domestic demand in Korea is slowing. Thailand's inflation rate, meanwhile, is at its highest level in five years.

That economic trends are beginning to diverge from inflationary ones may sound fine, given that inflation is a lagging indicator. What's different this time, though, is how much of Asia's growth in recent years has been driven by low interest rates.

`Bubble Fix'

It reflects what economists call ``the Bubble Fix,'' caused by central banks going too far boosting economies. Easy money reduces the need for structural reforms and artificially pumps up asset prices.

Not everyone is convinced Asia's is about to return to the 1970s, when large economies like the U.S. saw unemployment and inflation surge in step.

``Stagflation does not appear to be an immediate threat across Asia,'' says David Cohen, an economist at Action Economics. He points instead to signs the region is experiencing `healthy growth'' with ``generally benign inflation, despite some pressure from global commodity prices.''

Low rates have led to bubbles in global property markets, prompting consumers in wealthy developed nations to spend feverishly. Easy money also has boosted Chinese capital spending, lifting Asian manufacturing economies and commodity ones, too.

Strangely, Asian governments seem to be doing more to avoid inflation than central banks. Chinese officials, for example, have been trying to cool sales of property and autos. Yet China's central bank has yet to raise interest rates.

The Risks

Central banks are supposed to weight all risks to an economy and rein in system-wide excesses. Monetary authorities here in Asia seem to think an eventual slowdown in global growth will temper inflation. Such a go-slow approach may be at odds with risks throughout the region.

``Central banking is about risk management,'' Xie says. ``Interest rates are already too low and the Middle East is unstable. Central banks should build up some safety margin now by raising interest rates, even though it may speed up economic deceleration.''

To contact the writer of this column: William Pesek Jr. in Jakarta at at wpesek@bloomberg.net.

Last Updated: July 14, 2004 16:33 EDT