Rising inflation is causing concern around the world. People are demonstrating about higher food prices in developing countries, while there are rumblings of discontent about high fuel costs in developed ones. And, naturally, this is getting the politicians' attention everywhere. It is also causing investors to become more vigilant about the consequences for asset returns.

Government bond yields have been rising in Europe, Japan and North America, as higher inflation expectations are priced into the instruments. Headline inflation numbers that are being released are worrisome, and the rise in commodity prices does not portend well for the future trend.

Energy and agricultural commodity prices are the focus of attention, but precious and industrial metals are also being monitored. The spurt in commodity prices over the past six months has its origins in the manner in which the Fed has flooded the system with liquidity to try and reduce the impact of a bursting housing bubble and problems in the financial sector.

Negative real interest rates have increased the attraction of commodities as a hedge against inflation. Furthermore, economic growth in fast-growing commodity-consuming countries has held up well compared with the G-7 tortoises.

The commodity boom is now in its fifth year and while it is now somewhat bubbly, there is little indication that a historical correction of major proportions is in the offing, rather than a more measured retracement from over-bought conditions.

This is a general statement about the asset class as a whole. Individual commodities have particular supply/demand conditions, characteristics and role in different phases of the business cycle. Those that have run up significantly may also be subject to a sharper downturn. The extent of future price movements will depend on the vigour of global growth and the response of monetary authorities in validating or opposing inflationary trends.

Looking at the supply side of the energy and industrial metals sectors, production response to the bull market of the past few years has been slow. It is well known that the previous long bear market resulted in an under-capacity to produce. And the producers are not rushing to increase capacity. It reflects caution on their part, because of the substantial capital investment required and the long period before output can be brought to market. Generally, firms in the industry do not have good skills in forecasting long-term demand.

In the agricultural sphere there is a mix of factors. Some are weather-related and tend to be self-correcting; by the time the next crop is ready to be harvested. There are also lagged responses of over or underproduction, depending on price overshoot or undershoot in the previous period. Regarding longer-term issues of global warming, the distribution of the production of particular commodities may change, though their total output may not be much affected. For example, we may end up with higher yields in Canada and lower ones in Australia.

On the supply side, some input prices have risen substantially. This includes fuel to run farm machinery and the price of oil-based fertilisers. Some agricultural products may also be benefiting from an increase in demand as rising income levels in developing countries leads to higher consumption. But the importance of this factor is usually exaggerated. Most of the change in demand is in the form of the substitution of "luxury" foodstuffs for basics - in other words, the composition of demand changes.

However, we do take note of the argument that the substitution of a "luxury" product such as beef for grains can lead to an increase in demand for grains because more of it is required to raise beef than if it is consumed directly. But the fact remains that the overall rise in demand is a function of population growth, which occurs steadily and does not appear to have experienced a strong spurt in recent years.

A notable feature of recent trends has been a strong interest in commodity investments from institutional investors. They hope to achieve greater diversification by investing in an asset class with historically low correlation with equities. Other characteristics that they perceive as being attractive are a hedge against inflation and a stake in fast-growing economies.

The magnitude of the demand from institutions has been strong this year, so much so that some hedge-fund veterans in the sector have been wondering whether this represented a peak and it was time to exit. However, it appears that diversification demand from the institutions has not dried up yet. If this is correct then it may provide some cushion when sell-offs occur.

Speculation is, of course, rife in the sector, attracting both big and small investors. Traditionally, according to Wall Street lore, the arena of commodity futures trading has provided sport, where professionals regularly beat up dentists and other amateurs. Also, the game is played very seriously, by investment-bank prop desks. Goldman Sachs analysts produce forecasts of the commodity markets, even as their traders bet the firm's money in a variety of ways.

There is increasing evidence that firms are passing along higher costs to their customers. Of course, not every corporation has clout, but any firm that has a degree of pricing power will try to preserve its profit margins by pushing through price increases. We are hearing more about FIFO accounting, something that is usually applied in inflationary environments. For those who have forgotten its meaning, it means that a company uses the prices of the most recently bought inputs to determine the cost of goods sold.

The attempt to pass along costs will work its way through the system, showing up in final consumer-goods prices. Already, US consumer expectations of inflation have risen, as indicated by recent surveys of consumer sentiment. The story is much the same in many other countries.

The official inflation numbers reported by the US government are widely disbelieved. It does not square with people's experience in the real world. Many analysts have taken the trouble to crunch their own numbers, confirming the downward bias of the official inflation data. Bill Gross of Pimco, who as manager of fixed-income securities should be particularly concerned about inflation, reports that it is understated by at least one percentage point.

Over in the Eurozone, the headline inflation rate has risen to 3.6 percent, up from a previous reading of 3.3 percent. Evidently, this is way above the European Central Bank's target of a maximum of two percent. Furthermore, it is expected that the inflation rate will edge up in coming months. Meanwhile, there are increasing signs of weaker growth in the common-currency area.

Consumer spending in Germany, the biggest economy, is becoming more wobbly. With one engine sputtering, Deutschland has to depend on the other two, namely exports and investment spending to power the economy. At the same time, other countries such as Spain and Italy, facing weak growth, would not mind the kind of liquidity flood that the Fed has provided the US economy.

However, the ECB mindful of its inflation-fighting credibility is not going to oblige. Furthermore, unlike the doctored American data, the inflation statistics for the Eurozone are commonly regarded as being fairly reliable.

In the UK, Mervyn King, the Bank of England governor, is polishing up his letter-writing skills. According to the rules, when the inflation rate strays by more than one percentage point from the two percent target, the guv has to write a letter to the chancellor explaining why, as well as what he is going to do about it.

He must keep on doing this He must keep on doing this every three months if inflation remains outside the range.

The latest UK inflation reading of three percent only just saved King from the letter-writing task. But expectations are that the target will be breached and the governor will have to put pen to paper in the near future.

Over in Downing Street, Gordon Brown, who is floundering in the polls, has signalled that he is only too keen to receive letters from the governor. What is wrong with some inflation if growth can be goosed up and the grouchy electorate hopefully made a little happier? And at the end of the day you can blame the "independent" Bank of England (BoE) for getting monetary policy wrong and fuelling inflation.

The BoE is indeed in a tough spot, as are all other central banks. It is facing the challenge of slowing growth and rising inflation. Policies aimed at solving one of the problems risks exacerbating the other. Measures of inflation expectations garnered from consumer surveys and gauged from the yield on index-linked bonds are both well above two percent. So it seems that people are unconvinced that the Bank's Monetary Policy Committee (MPC) has the resolve to tackle inflationary pressures.

In a weak economy tight credit conditions will undoubtedly cause pain. But being soft on inflation has even more serious costs. There is a risk that inflationary expectations will become entrenched and once they become part of the common calculus and embedded in wage and price formation it will be difficult and costly to remove.

The mistakes of the 1970's, when many central banks validated inflation instead of fighting it, should not be repeated. Those bankers who think that "it is different this time" and that they can manage everything by fine-tuning exercises should examine their own sorry record over the past few years. If they need lessons in central banking they can also write to Paul Volcker (a former Fed chief) for sound advice.

The MPC committed the error of keeping liquidity too easy for too long, in the past few years. As we have stated before, virtually all the other central banks have been guilty of the same misdemeanour. But those were, as Mervyn King has said, the "nice" years. A stable low-inflation environment based on specific global conditions encouraged the bankers to aim for maximum economic growth.

This led to excessive risk-taking and the formation of asset bubbles that eventually unravelled. Claims, prevalent at the time, that the central banks had perfected the art of fine-tuning the economy were totally unfounded, as the outcome demonstrates. Visible and invisible rot was setting in while they carried on blithely furnishing liquidity to the system.

Back in early 2006 riskier assets began to sell off in the expectation that central-bank tightening was around the corner. But the signal from the authorities was that everything was fine, upon which riskier assets continued to race higher.

So welcome to the "vile" decade that the bankers have ushered us into. In passing, we have to thank Mervyn King for employing this most appropriate adjective.

As mentioned above, policymakers have their work cut out for them.

Both measured inflation and expectations of future inflation are on the rise in many countries around the world, whether in the developed or developing category.

Essentially there is a need for a period of slower growth for the global economy to wring out the building inflationary pressures.

At this point in time, higher expectations have not yet become fully entrenched and appropriate action may prevent this from happening.

But the risks are rising and policy mistakes aimed at preventing the pain of slower growth may end up stoking inflation fires.

This is particularly true of the US where the Fed has taken extremely aggressive action to prevent a growth slowdown. In doing so it is also taking the risk of validating inflation.

At this stage, given the continuing problems in the housing and financial sectors, it seems unlikely that the US economy will experience a rebound in the second half of the year.

But should there be any measure of success in boosting growth it will mean bad news on the inflation front.

We expect to see a good deal of volatility on global financial markets as views change on the prospects for growth and inflation.

The least likely scenario is one of high growth and low inflation.

Going forward, we should continue to monitor the central banks regarding their inflation-fighting credibility.

After Dick Cheney and George Bush's recent visits to oil-rich Persian Gulf countries it is Henry Paulson's turn to do the grand tour.

Why have so many notable administration figures done this in so short a time frame? Could it be that their message is not getting across? One of Paulson's messages is that economic liberalisation is a good thing. Well, the audience may retort, how about practicing the free-market principles that you preach, back home?

And get this; Hank sees no contradiction in proposing economic liberalisation and simultaneously promoting the maintenance of local currency pegs with the dollar!

And of course he wants plenty of cheap oil. But why should the Arabs be interested when they are exporting a whole lot more to Asia than to America, and the trend will become even more pronounced in the future.

What is happening is that the balance of economic and political power in the world is shifting, to the detriment of the US.

As far as the Middle East is concerned, the consensus is that the Americans have damaged their own strategic interests over a long period.

Their Chinese and Russian competitors must be delighted to have an adversary that is so adept at head-in-the-sands and shoot-yourself-in-the-foot policies.

Iraj Pouyandeh is a Strategist and senior portfolio manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com