Is inflation making a comeback?


The currency and commodity markets are always on the lookout for the next factor that will drive markets.
At the moment, there are two major worries.
First, market watchers are worried about the US economy’s health, after important economic data over the last few months came in below expectations.
The other major driver has been the debt troubles of Greece and other European nations.
But looking forward, many analysts believe that rising inflation is the next major worry for financial markets.

The rising dragon

Inflation hasn’t really been a problem for western economies over the past 20 years. There are a couple of theories why inflation has been tamed in this time. One theory is that inflation has been controlled by a change in central banks’ thinking in the 1980s.

Central banks, such as the Reserve Bank of Australia and the Bank of England, now focus all their attention on making sure inflation is at a reasonable level. Before this, central banks tried to ensure the economy was going well, that jobs were being created, and that currencies were relatively stable, but now they just focus on inflation. Another theory is that China’s entry in the global economy as a major manufacturer has kept the prices of goods low.

But we are now in an environment in which central banks are actually trying to encourage inflation. Most particularly, in the US, the Federal Reserve has been trying to generate inflation as a way of kick-starting their economy. And, while China has helped the world keep prices low over recent years, they now have problems with inflation. There is an expectation that China will soon be suffering from inflation of more than 6% a year – well above the danger zone for the economic powerhouse.

Just Right

It’s important to remember that inflation isn’t necessarily a bad thing. A healthy level of inflation, say around 2%-3% per year, is actually a sign of a growing economy.

High inflation is bad, but so is very low inflation. The Japanese economy, which has been struggling for 20 years, has been hard hit by deflation, when prices actually fall. So, inflation is just like Goldilocks’ porridge: it’s best when it’s not too hot and not too cold. We want it to be just right.

State of play

At present different parts of the world are facing different inflationary problems. While the US and Japan continue to struggle with very low inflation, the rest of the world is becoming worried about high inflation levels.

Inflationary effects are most obvious across Asia. China began raising rates last year to head off inflation. The European Central Bank, even in the midst of its member state’s debt crisis, has been forced to raise rates in July and said it might need to do it again soon.

Commodity corner

Inflation is a nasty business, but that doesn’t mean that astute traders can’t make money from it.

The major trade for those who are worried about inflation is gold. This is because gold is seen as a store of value. No matter what happens in the world, gold will still be valuable. The actual value of gold will change depending on financial conditions, but unlike paper money, gold has a ‘real’ value.

But it’s not just gold that benefits from inflation. Other precious metals such as silver can also experience big gains in an inflationary environment, while agricultural commodities, such as wheat and corn, also generally trade higher.

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