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US inflation will be stubbornly high in the years to follow, says LGIM

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At today’s Fundamentals briefing, LGIM Economist, Tim Drayson (pictured), contended that inflation will become a larger problem than most investors and policy makers currently anticipate.

Drayson explained that the US has enjoyed two decades of economic growth without problematic inflation leading to some complacency as market participants have become used to a low inflationary environment.

“For the past two years, the US Federal Reserve (Fed) has been more worried about deflation than inflation. We believe the US growth and inflation mix is in the process of deteriorating significantly – which will pose a dilemma for the Fed," he says.

Drayson identified five key dynamics which have kept inflation low in the past and which are now reversing:

1 The role of commodity prices and the dollar – as a relatively closed economy, the US has historically seen minimal impact from movements in commodity prices and currency fluctuations. Now, faster growing developing economies are rising in importance, dollar weakness may persist and there could be a structural rise in commodity prices driven by emerging market demand.

2 China’s rapid growth is leading to higher prices and surging wages. As a result, competitive pressures on US manufacturers (from low-cost Chinese labour) are now diminishing, allowing them to pass on higher cost increases with less fear of being undercut by foreign producers.

3 Rising rents to reflect a structural shift in demand away from owning property

4 Wages did not fall as much as expected during the recent crisis and it is possible that the Fed has misjudged the amount of labour market slack.

5 The structural effect of Quantitative Easing (QE) remains unclear but it could add to inflation if the Fed fails to shrink its balance sheet in time.

Drayson concludes that “most of the factors which supported a favourable growth and inflation trade-off over the past twenty years now appear to be reversing – this points to disappointing growth and stubbornly high inflation in the US during the next few years. While a serious inflation outbreak is unlikely in the next 18 months, we expect the Fed to start raising official interest rates earlier than the market anticipates, with the cash rate moving to around 2% at the end of 2012”.

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