Outlook: Inflation back?

NO SOONER have forecasters decided that the great bull market in bonds is definitely over, than the market stages a modest recovery. The benchmark 30 year US Treasury bond rebounded a bit yesterday from its march towards the 6 per cent level. However, there's no doubting the fact that inflation has knocked deflation off its perch as number one worry for international markets.

How well founded is this concern? Alan Greenspan set the cat amongst the pigeons last week with his speech warning that the combination of an ever-tighter jobs market and low inflation could not last forever, even with a big improvement in productivity. The Federal Reserve Chairman, formerly suspected of being a believer in the "new economy", declared that the laws of economics had not in fact been suspended.

But even if the faithful have had their hopes of an economic miracle dashed, it is hard to understand why yields on US Treasury bonds should have risen so rapidly in recent weeks. Certainly, demand in the world economy has staged an impressive recovery from last year's depths, and commodity prices have picked up.

The market also seems pretty sure that the Federal Reserve will raise interest rates before too long. Add in a fear that foreign investors as a group will eventually baulk at financing the US deficit, which reflects the growing indebtedness of American consumers, and the rise in Treasury bond yields looks a bit more explicable.

Even so, the fear of inflation may be exaggerated. Growth this year will be nothing dramatic outside the US. The potential for further increases in commodity and basic goods prices is limited, because last year's crisis means there is plenty of spare capacity to come back on stream if the incentive is there.

It is in the nature of economies to experience business cycles, and in the late stage of a cycle inflation climbs. As Mr Greenspan said, the laws of economics still operate. But as he added in the parts of his speech less closely scrutinised by the bond market, this cycle is different. The performance of the US economy has been phenomenal.

What he didn't point out is that once again he has managed to get the bond market to do his work for him. A rise in long term interest rates is much more effective in dampening growth and inflationary pressures than action at the short end. So merely by hinting at the threat of higher inflation, Mr Greenspan is postponing the evil day.