In the past few years, the conventional wisdom had become that deflation was the big danger. Many unhesitatingly opined that it was China that was the principal exporter of this deflation. It is always nice to be able to place the blame on someone else. It apparently never struck these scintillating analysts, who mould so much of the economic opinion across the world, that the China cocktail of 8 per cent growth, 40 per cent plus investment rate, huge unsterilised capital inflows fuelling rapid monetary expansion and bank lending, was much too heady. The after-effects were predictable, even if the timing was not, and that inflation was bound to be one of the consequences. It was interesting to read the week before last a business story headlined ?Newest Export Out of China: Inflation Fears?. It was of course based on the expert opinions of well known houses in the financial services industry ? the same ones who preached the gospel of how very low interest rates were necessary to save the civilised world from the demon of deflation being exported out of China!

Consumer prices in the US turned sharply up in March and not just because of petroleum. In March 2004, the increase in the consumer price index (CPI) over March 2003 was 1.7 per cent. Where is the increase in inflation one might ask? Here: In the first three months of 2004, the seasonally adjusted compound annual rate soared by 5.1 per cent. Excluding food & energy, the increase between January through March was 2.1 per cent, nearly double that of the previous quarter?s 1.3 per cent. In March, with respect to February 2004, the seasonally adjusted annual rate was 6.2 per cent, and even if one excludes food & energy it was 4.9 per cent. February numbers were lower, but above that of earlier months. Producer prices for finished goods in March 2004 headed up further with the seasonally adjusted annual rate for the January-March 2004 quarter notching inflation of over 5 per cent.

In the other big economic region, the Euro zone, CPI inflation with reference to the same month in the previous year went up to 1.7 per cent in March 2004. Which does not seem high, except that the currency was 13 per cent stronger than the dollar and currency appreciation normally has deflationary outcomes. Moreover in March 2004, the annualised inflation rate with respect to the previous month was as high as 8.7 per cent, and excluding energy it was 7.4 per cent. This despite a tepid 1.2 per cent (annualised) growth in GDP in the fourth quarter of 2003 relative to the third quarter, and 0.6 per cent compared to the same quarter in 2002. Most of the European economies outside of the euro-area have done somewhat better with stronger economic growth and lower inflation rates ? notably the UK, Sweden and Denmark.

Australia ? benefiting perhaps the most from the boom in the China-led worlddemand for minerals ? was the first developed country to raise rates in the current round, moving the cash target rate up by 25 basis points (bps) to 4.5 per cent in May 2002. Three subsequent increases of 25 bps each have raised the target rate to 5.25 per cent presently. The Bank of England reversed course later in November 2003, when it raised the repo rate by 25 bps to 3.75 per cent and again in February 2004 to 4 per cent. The European Central Bank (ECB), tied by its strong mandate of inflation targeting, has held the rate at 2 per cent despite the strong appreciation of the euro that certainly was hurting the economies in the union. With inflationary tendencies now reinforced, the possibilities held out by many in 2003 that the ECB might relent a bit, is now clearly out of the question.

You must have read Paul Krugman on interest rates last Saturday in this newspaper, so there is no reason to repeat some arguments. It is of course a matter of opinion whether other peoples? calculations would lead them like Krugman to a 1-year US government bond rate of 7 per cent or a mortgage rate of 8.5 per cent. The yield on 10-year bonds has risen from 3.75 per cent in mid-March 2004 to above 4.4 per cent presently ? a solid rise of 65 bps. One of the outcomes was that the dollar has gained more than 10 cents and is trading well below its 200 day moving average, with the possibility of further dollar strength in the offing. It is only fair to mention that US bond yields had systematically risen since end-July 2003 to over 4 per cent and had tested 4.5 per cent levels in August and September 2003, before easing in February and March 2004. The rise in yields in the summer of 2003 flowed from a rational market reaction to a large and increasing federal budget deficit, and indications that the economic recession was over. The slide in yields more recently was the irrational attraction to the idea that a technological breakthrough had perhaps been made permitting large and expanding fiscal deficits, economic recovery and low policy rates to co-exist indefinitely.

Which finally brings us back home. We too have had a period of declining and low (by our standards) interest rates along with large fiscal deficits. In fairness, these deficits today may be seen as easing, rather than expanding. Further, we have had strong growth in industry and services ever since the summer of 2002, notwithstanding the drought. The co-existence of mutually hostile elements has been made possible to some extent by first, the fact that starting out our interest rates were geared to a much higher rate of inflation. Second, this was the period of plummeting interest rates the world over. However, there was another reason as well, namely large unsterilised capital inflows. For the period 1999-00 to 2001-02, the reserve money statistics indicate that large increases in net foreign assets were not accompanied by any offsetting reduction in the Reserve Bank of India?s credit to government. The economy is still accelerating, an investment cycle is clearly in the offing and inflationary pressures that began in early 2003 show no real signs of abatement. Liquidity will inevitably tighten and interest rates move north, in consequence both of policy and market conditions.

The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)