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Busch: What If The Unthinkable Inflation Returns?

Currently, there are two places in the world that are experiencing significant increases in prices and more may be coming. India's Federal Chief Statistician Pronab Sen told a private television channel on Tuesday that the monthly inflation may touch double digits by March according to the Times of India. "It is really possible," he said. India's wholesale price index rose to 7.31% in December from a year earlier, driven by higher food prices. Processed food items rose 26.40% in December and non-processed food items increased by 19.17%. The Reserve Bank of India had only projected a 6.5% overall inflation rate and may be forced to begin raising interest rates soon.

The UK announced the largest increase in inflation since records began in 1997 with December consumer prices rising 2.9% from a year earlier and full percent higher from November. Core inflation accelerated to 2.8% and is the fastest rate of increase on record. This breaches the Bank of England's 2% target for the first time since last March and potentially complicates their quantitative easing program. Currently, the BOE benchmark interest rate is at an all time low of 0.5%.

Both the UK and India stimulated their economies by cutting interest rates aggressively during the financial crisis in 2008. The exit question is now front and center with the global economy recovering and inflation rates accelerating. The world central banks have been operating under the assumption that due to high unemployment that inflation would remain tame.

What if they are wrong? What happens if the velocity of money begins to increase in a meaningful way?

In December, we had a taste of what the US bond market can do once it begins to shift it's expectations for economic growth. The 65 basis point rise in the US 10 year note yield caught everyone by surprise and we're now awaiting to see what other banks may have missed fixed income earnings expectations. More importantly, the US government auctions will be less and less attractive to investors.

Given the trajectory of US government deficit spending for 2010, the concern over inflation will be persistent as US growth continues into the first quarter.

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Andrew B. Busch is Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.