The inflation threat: unlikely for the developed world, but highly probable for China.

• Author: Lo, Chi

U.S. Treasury yields have risen decisively from their lows in December 2008. Many market players argue that the U.S. bond sell-off, which has led to the rise in yields, was a result of an inflation scare. This premise for the rise in yields is wrong, as the inflation threat will likely remain very small through 2010, if not longer, in the developed world. But the inflation threat is more real for China because it does not have the financial impairment that the developed world has. While interest rates may remain low for a long period in the United States, as Fed Chairman Ben Bernanke recently pledged, in China the risk of a monetary policy shift there is on the upside in 2010.

INFLATION SCARE OVERPLAYED IN THE DEVELOPED WORLD

Many analysts attribute the rise in long U.S. Treasury yields since December 2008 to worries about a soaring fiscal deficit, which will lead to a massive government bond supply and a fiscal crisis, and the Fed's quantitative easing, which will lead to runaway inflation later. There is no doubt about the fear of massive public sector borrowing leading to a surging government bond supply in the coming years. But the worry about a soaring fiscal deficit causing a debt crisis and another round of financial chaos is not necessarily justified.

In general, a government debt crisis is rooted in excessive fiscal spending. But the economic impact can be either inflationary or deflationary. If the spending is debt-financed, it is deflationary because public borrowing competes with private credit demand, driving up bond yields and the exchange rate, and thus damaging the economy. If the spending is financed by central bank monetization, as is the case currently in the developed world, it is inflationary. Money printing boosts demand, forcing the exchange rate to depreciate, and finally pushing up bond yields.

Thus, many market players attribute the recent rise in long Treasury bond yields to the Federal Reserve's quantitative easing effort. Back in June, the market was even pricing in a Fed rate hike later this year. While this rate hike expectation has faded, it will return. This expectation is myopic. Disinflation with periodic deflation is a more likely outcome than soaring inflation in the developed world in the coming year, if not longer. The output gap opened up by the subprime crisis is large and will take a few years to close. This is deflationary, not inflationary.

It is also not obvious whether U.S. government spending...