As food and energy inflation climb to their highest levels since 1990 worldwide, central banks in Latin America, the Baltics, Balkans and South Africa are raising interest rates. And if the U.S. was fighting a toxic cocktail of both inflation and deflation, the U.S. would probably raising rates too.

But now that commodities are hitting all-time highs, investors are losing confidence that central banks can arrest inflation.

Gold hit an all-time intraday high of US$1,033 an ounce in March. And now gold is heading to breach that level over the next few weeks, if not sooner.

Gold continues to blast past all currencies since 2005 – including the mighty euro, Brazilian real and the Canadian dollar. This tells me that despite big gains for most currencies against the dollar this decade, they pale in comparison to gold and other hard assets.

Monetary reflation is now alive and kicking just about everywhere. Central bank broader monetary aggregates continue to post high single or double-digit gains over the last 12 months. Authorities are growing desperate to revive sagging growth caused by the U.S. slowdown.

The U.S. dollar is probably one of the most undervalued currencies in the world at this point following a severe decline since 2002. I would not dump dollars now. Most U.S. assets from a foreign currency perspective are absolutely dirt cheap!

But if you expect a “muddle through” economic recovery to persist over the next 12 months – and I do – then the Fed will have to stay on guard as housing attempts to establish a bottom. This doesn’t imply the dollar must fall further. But it does suggest commodities and gold will continue to rally because most central banks will continue to print credit while they try to look concerned about inflation.

The majority of central banks raising rates in 2008 are only gradually draining liquidity from the financial system. These banks are also the smaller players on the global stage. The banks that matter most in creating inflation – the Fed and the ECB, however, continue to print credit and inject funds.

Inflation is trying to win and overcome deflation. In time, I’m betting on inflation.

ERIC ROSEMAN, Investment Director

Source: The Central Bank Mirage, Part II