INFLATION / THE FINANCIAL TIMES LEX ( HIGHLY RECOMMENDED READING )

Inflation

Published: July 1 2010 09:43 Last updated: July 1 2010 19:25

Even a child receiving $5 a week pocket money understands that rising prices are painful. Alternatively if he expects baseball cards to be cheaper in the future, he will save his money now. Central bankers are usually most concerned about keeping inflation down, but markets are now forcing them to consider deflationary scenarios.

Ten-year break-evens on US Treasury inflation-protected securities have dropped from almost 2.5 per cent to 1.8 per cent since April, while the spread between the yields on 10-year and two-year Treasury bonds is at its lowest in a year; remarkable given concerns about government deficits. Commodity prices are falling. And the recovery in jobs and output remains anaemic, as governments are withdrawing fiscal stimuli.

Yet hyperinflation doomsayers are still on their soapboxes. They point out that the US monetary base has increased more than 140 per cent in the past two years, while quantitative easing has had a similar effect on the money supply elsewhere in the western world.

As all the cash works its way through a system with near-zero interest rates they fear catastrophic consequences. Helpfully, they also point to a way to profit from disaster. Several big investors who predicted the credit crisis have bought gold.

But in a deflationary environment they should be careful. Japanese experience shows that an increased money supply does not necessarily translate into inflation. Since 1990, its money supply has increased 145 per cent yet prices have generally gone backwards.

Historically, the gold price has followed money supply growth. But since the crisis other factors, such as sovereign risk and equity market expectations, have also boosted the price of the yellow metal. But investors falling for the marketing spiel of hedge funds launching products denominated in gold need to watch out. If gold continues to detach from otherwise deflationary fundamentals, their returns will be crucified no matter how cleverly the assets are managed.

Copyright The Financial Times Limited 2010.