Two factors occurring at the same time — the central banks’ determination to keep inflation low and the influx of inexpensive imports from China — make inflation a non-issue for many strategists and money managers. But has inflation really gone away?

When analysts say it’s no longer a problem, they mean two things. First, they believe central banks are determined to keep inflation under control and will do whatever is necessary to keep it low. Second, they believe the increasing flow of inexpensive goods from low-wage countries, particularly China, will offset inflationary pressure coming from higher prices for resources, such as energy, and services.

Inflation — or the lack thereof — is a key assumption behind the recommendations of strategists and the positioning of money managers as 2006 gets underway. Most of those interviewed for Investment Executive’s Outlook 2006 special report (see pages B1-B24) think inflation will be benign, despite high oil prices. As a result, they expect only a moderate slowdown in growth in the U.S. and around the globe.

Only Nandu Narayanan, chief investment officer at Trident Investment Management LLC in New York and manager of several funds for CI Investments Inc., thinks oil prices will continue rising as long as there is healthy global growth — US$100 a barrel is not inconceivable, he says — and won’t fall much even if there is a severe recession. This will result in higher wage demands and, thus, push up overall inflation. Narayanan is predicting global inflation of more than 4% this year, significantly above the 2%-3% that is commonly assumed.

Nor does he think central banks will be able to quell inflationary pressures, no matter how determined they are. It would take real interest rates of 2%-3.5% to slow the U.S. economy sufficiently to eliminate the upward price pressure, he says. If inflation were 4%, that would translate into 6%-7.5% nominal rates. The consumer would be pushed over the edge if rates reached 6%, he says, and would drag down the housing market down with them. Thus, he expects the U.S. Federal Reserve Board to accommodate the inflationary pressure in order to avoid a very severe recession.

And those inflationary pressures will be global, Narayanan says. Governments in India and China are subsidizing domestic energy prices; authorities in those countries may have to raise domestic prices if world oil prices keep climbing.

But Narayanan is alone in this view among those interviewed. Most of those surveyed remain convinced that inflation, at least for now, is not a major risk.

The argument that central banks won’t let inflation get out of hand is a most persuasive one. It means that as long as central banks maintain their determination, inflation will not take off. It does not, however, mean there won’t be inflationary pressure or that there won’t be rising interest rates to cool that pressure off. It only means analysts — Narayanan excepted — believe the central banks can and will deal with any signs of rising inflation quickly and effectively.

But the theory that inexpensive goods from China are keeping a lid on inflation is the more reassuring of the arguments. If, indeed, there is enough downward pressure on the price of domestic goods because so much is imported from low-wage countries, that may well prevent a sustained rise in the overall inflation rate.

There is certainly no argument that inflation to date has remained low despite the very high oil prices. The headline consumer price index has moved up in the U.S., coming in at 3.5% this past November. However, the core rate, which excludes food and energy, was just 2.1%.

Analysts and central bankers focus on the core rate because food and energy prices are so volatile. It is only when increases in food and energy costs are reflected in the core that anyone worries. Clearly, that hasn’t happened yet.

The question is whether that is likely to continue. Most analysts expect oil prices to recede this year, but not dramatically. They think prices will remain above US$40 a barrel, and many assume they will be in the US$50-US$55 range. Those are still very high levels and push up costs significantly for many businesses.

The most obvious example is transportation, in which fuel is a major input. Peter O’Reilly, global money manager at I.G. International Management Ltd. in Dublin, a division of Investors Group Inc. , was worried a few months ago about increases in rail rates of 16%-17%. But he is less concerned now. So far there’s no evidence that the companies who are using the railways are increasing their prices significantly.

@page_break@Analysts point out that energy efficiency has increased dramatically since the 1970s, with one barrel of oil producing twice as much output today as it did 30 years ago. This has reduced the impact of high oil prices.

Most economists think that as long as oil prices stay at less than US$70 a barrel, consumer spending will not be seriously affected; some think prices wouldn’t really take a bite out of spending until they reach US$100 a barrel or more.

Nevertheless, O’Reilly, who expects oil prices to be between US$50 and US$60 a barrel, says inflation bears watching. The reason it has stayed down is not because it’s no longer a threat but rather because there’s a reasonable amount of excess capacity in the U.S. and because strong productivity growth is providing offsetting cost savings.

John Arnold, portfolio manager at AGF International Investors Inc. in Dublin, expects oil prices to drop to the US$30-US$40 range. And although companies have been able to put price increases through when needed without running into resistance, he does have some inflationary concerns.

“Unions around the globe are being more vocal than they have been for a while,” Arnold says. He thinks it unlikely that the levels of union militancy of the 1960s and 1970s will be repeated. But militancy is growing. That doesn’t surprise him, given that wage levels have been held down during the past five years while corporate profits have grown. Nevertheless, he thinks inflation will be contained, mainly because of the huge amount of production coming out of China.

Bill Sterling, chief investment officer at Trilogy Advisors LLC in New York, thinks there will be some upward price pressure. But he believes it will be contained. Labour doesn’t have the pricing power to demand big wage increases, given the threat of jobs moving overseas. However, he is counting on a moderate slowdown in U.S. and global economic growth to ensure that inflation doesn’t take off.

There’s also the argument of Gavin Graham, vice president and managing director of Toronto-based Guardian Group of Funds Ltd. ; inflation is one of the major themes he sees developing. His thesis is that the worldwide shortage of hard assets, such as energy, metals and alternative fuels, inevitably will push up general prices. But he sees it as a long-term development rather than a cyclical spike.

Although there is no immediate threat, O’Reilly thinks food prices are likely to rise. Indeed, he thinks food could be the next oil because of all the people in emerging countries, such as China, moving into cities. In rural areas, they could grow their own food; in the cities, they have to buy food. Food is an essential. Labour may swallow price increases for other items, but if they are having trouble paying for food, they will demand higher wages.

This suggests inflation may be more asleep than dead. It also raises the question of whether focusing on inflation figures that exclude food and energy is still a good idea.

It does not negate the argument that if the central banks are determined to keep inflation under control, they will do so. But it does raise the question of what the cost of suppressing inflation will be.

The only way to keep inflation down is to slow economic activity sufficiently that there is not enough demand to allow companies to increase the price of goods and services to recover the full costs of producing them.

And the price of that could be a very severe recession. IE