Won’t the rate cuts, together with the huge bailout packages both in the US and in Europe, lead to a resurgence of inflation? Merrill Lynch economist David Rosenberg has instead been warning of deflation, pointing out that action taken by the central banks is aimed at offsetting the deflationary impact from asset liquidation, debt repayment and increased savings. Writes Rosenberg: “We are getting asked repeatedly these days how it is that the government debt creation we are about to see is not going to be inflationary. After all, aren’t we going to see a boom in the money supply? Well, we’re sure that the money supply is going to increase, but at the same time, we are going to see the turnover rate of that money, or what is called money velocity, decline. This is exactly what happened in that 1989-93 period when the Fed massively reflated. Money velocity contracted 13% and this is the reason why the inflation rate was cut in half that cycle and bond yields plunged 400 basis points…"

In the early 1990s, despite the savings and loan bailout in the US and a series of rate cuts that took the Fed funds rate from 8.5% at the beginning of the year to 4% by the end of 1991, inflation declined from 5.4% in 1990 to 2.5% by 1994. Does it mean that bonds will be the place to invest during the downturn, just as they were during 2001-03 in India? That might not hold true for corporate bonds, though, given the liquidity concerns we have at present. But government securities have been doing very well, with the rally being fuelled by banks’ need to maintain statutory liquidity ratios. Gilt funds should shine in this environment.

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