“For the past two years the US Federal Reserve 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,” says LGIM.

While the US has benefitted from non-threatening inflation rates over the last two decades, LGIM predicts a turnaround, as it expects several key forces, which have served to keep inflation low in the past, to reverse and have the opposite effect on inflation.

Speaking to journalists, Drayson drew attention to commodity prices having a greater effect on US inflation, which has historically not been the case. As fast growing developing economies start to have a bigger impact on the global economy the US dollar may remain weak, while increasing demand from emerging markets is likely to result in a structural rise in commodity prices, says Drayson. 

The firm singles out China’s growth in particular as a leading cause of US inflation. With its growth, China can afford to raise its own prices and wages, which directly boosts US inflation, says Drayson, who goes on to explain that more indirect upward pressure on US inflation comes as a result of foreign manufacturers losing their competitive advantage of low-cost Chinese labour, thus allowing US manufacturers to increase their own prices with less fear of being undercut by their foreign counterparts.

Wages in the American labour market were not hit as hard as industry experts had expected, which may support inflation as “it is possible the Fed has misjudged the amount of labour market slack,” said LGIM. Another contributing factor to US inflation will be rising rents in the country, which will come from the shift in demand away from property ownership that is currently being seen in the US.

Drayson went on to discuss the possible inflationary effects quantitative easing could have on the economy. “It’s just impossible to model the impact of QE on inflation dynamics because we just don’t have the previous examples,” he said, but went on to tentatively suggest that, should the Fed hold excess reserves, it could encourage inflationary development.

Likewise, if inflation expectations increase, the velocity of money will increase with it, he said. This in essence represents the rate at which money circulates within an economy, representing how robust an economy is. High velocity of money could be a warning sign of hyperinflation.

Interestingly the LGIM economist did comment that he is doubtful over whether QE3 will be implemented, which chimes in with the results of the latest fund manager survey by Bank of America Merrill Lynch, which showed that two out of every three of the participating fund managers believe QE3 will not occur.

In summary, Drayson predicts the reversal of the forces that have kept US inflation low in recent years, which will lead to “disappointing growth and stubbornly high inflation in the US during the next few years,” he added.

“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 per cent at the end of 2012,” he concluded.