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In the past I have been optimistic about structural inflationary pressure within the UK economy as it has seemed to me that much of the strain has been imposed by products beyond the control of the Bank of England rate control policies. The price of Oil and Corn could not give a monkey’s about what the interest rate is in little old England. This argument still holds good to a certain extent but the recent moves in worldwide commodities mean that producers will be forced, yet again, to either raise prices or squeeze margins. In the economies of China and India the pressure will be taken up by inflationary price hikes. However with the ‘old’ economies, which are weighed down with debt or slow growth (or a combination of both), it is more likely to be margins that take the hit. Not a good prospect for the Stock Markets.

As Simon Denom of Financial Spreads recently said, “Since the turn of the century events have conspired to keep inflation low even in booming economies no matter what the central banks were doing. The euro zone has had a wildly divergent growth pattern with Ireland and Spain roaring away whilst France and Italy have struggled but the inflation rates in all the various countries has remained very much on an even keel. Whilst Central Bankers have patted themselves on the back for keeping the ‘inflation monster’ in his bottle it is difficult to get away from the feeling that he would have remained firmly stopped up even if rates had been at much lower levels”.

Even so in June the European Central Bank set the cat amongst the pigeons by being the first of the major blocs to indicate that, far from wishing to protect growth with rate cuts, they are more inclined to fight inflation. In the forex spread betting markets, or pretty much any other currency market, Jean Claude Trichet sent the Euro flying against the Dollar as traders bought into the higher yield story.

Until Mr Trichet’s statement the markets had been quite somnolent over both the Bank of England and ECB rate announcements (unchanged as expected) with the general trend actually towards a fading Euro. His effective guarantee of a rate hike in July was truly a surprise and flies in the face of more recent central bank policy of trying to float intentions via less outright methods.

What the weaker economies in the Euro bloc must be thinking at the moment is probably unprintable as the ECB once again focuses solely on events in France and Germany and ignores the struggling satellite nations. Italy, Spain, Portugal, Ireland and Greece (the unflatteringly named PIIGS) are seriously struggling with massive economic problems which are not being helped by either the strong currency or the high interest rates.

Mr Berlusconi in particular, never a fan of the EC experiment, must be seriously tempted to publicly voice disapproval with ECB policy and to once again shake the weapon of disengagement from the whole project.

Of course the mechanics of such a desperate measure are difficult to contemplate and therefore any threat along these lines will probably be pretty much ignored as being practicably unworkable. Can you imagine the effort required in turning all bank accounts back into Lire, recalling Euro notes to issue less valuable local currency etc. But, below the surface, there is plenty of dissatisfaction with the way that the central banks seem to concentrate on the major bloc partners. If this is truly building into the worst economic crisis since the nineteen thirties (an oft mentioned comparison that, frankly, seems very unlikely) then the stresses on the Euroland financial system are going to get a lot worse.

In the ECB’s defence they are, like the Bank of England, solely charged with an inflation fighting mandate and the Germans, of course, have historical experience of a Hyperinflation disaster. Unfortunately for policy makers the independence of the central bank is now working to undermine the whole stability of the Union itself.

For a number of years US economy has enjoyed a relatively low inflation rate. According to official statements, annualized inflation over last decade or so has been in very low single digits. Depending on the source and method of calculation, the rate has been about 2%. That is despite massive infusion of funds into the economy in the form of very low interest rates.

That course of action has been long supported by US financial authorities, the FED. For years the central bank has been concerned with growth, doing everything it could to fight economic slow down and stagnation. It was done in the form of cutting interest rates and seemingly endless liquidity increase. Let’s not forget about lending hand in order to bail out large financial institutions from the masses their questionable practises created. In fact, month after month we have been treated to speeches that inflation is under control and not a threat. Until now.

Published inflation figures pertain to the so called “core inflation”, compilation of prices on consumer goods, which excludes food and energy. Runaway cost increases in oil/gas and main food commodities are finally being reflected in the number, as their effects trickle down to other areas of consumer goods. Some of the newly released figures are stunning-soaring energy costs pushed inflation up in May at the fastest pace in six months, according to data released Friday by the U.S. Labor Department. Food prices had the biggest one-month leap in 18 years in April. That’s something.

Higher energy and commodity prices also fuel inflation pressures in other parts of the world. They are being acutely felt in Asia in particular, as the region continues to function as a commodity importer/manufactured goods exporter. One way countries can offset such inflationary pressures is to allow their currencies to appreciate more rapidly. All of a sudden, within a couple of weeks, the once neglected subject of inflation has catapulted itself onto front pages.

As of this writing in mid June, finance ministers of the of the Group of Eight industrialized countries (G-8) are holding a meeting in Osaka, Japan. Main subject have been inflation causing soaring oil and food prices, which are emerging as serious threats to global economic growth. The ministers are vowing to work together to address the problem. They urged oil-producing nations to increase production to help stabilize the spike in oil prices, and called for aid to address a looming food crisis in developing nations.

In response, Saudi Arabia pledged to increase its daily output by additional 500,000 barrels a day. This is surely to stretch their capacity to an absolute maximum, but in opinions of many this decision should calm energy markets, which, by the way, do not have a shortage of supplies. The recent run up of crude oil price to new high of about $140, is likely to be the extent of the rally for some time.

Where does it leave the dollar? There is no one certain answer, but her is one very possible scenario. Inflationary pressures are likely to cause FED to halt its rate cutting policy, maybe even to start gradual rate increases. That is always appealing to Forex traders. Falling oil prices should also benefit the dollar, as record energy costs have been vilified as the single biggest force behind USD weakness (rightly or not). And one more thing, Treasury Secretary Paulson warned earlier this week that he isn’t ruling out intervening in currency markets to stabilize the currency.

So, what is the relationship between US Dollar and inflation? Under current market conditions and in light of most recent fundamental and technical developments, USD might just get a much needed bust from the much dreaded inflation. This relationship is, however, fluid and unstable. Unchecked, inflationary forces can do just the opposite some time down the road- start another Dollar slide.