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Importing inflation

Inflation was in the news last week. Not only did we have the official UK figures, which showed the rise in the cost of living easing but still well above target but the Bank of England’s monetary policy committee minutes were published. Once again, Andrew Sentance disagreed with the other members of the committee and called for interest rates to be raised. His was a lone voice in the face of continuing uncertainty over the strength of the economic recovery.

The choice facing this distinguished group is a tough one. Inflation remains a concern. It can undermine economic performance and is hard to rein in if allowed to run unfettered. Yet it also has the merit of devaluing debt, which would be welcomed by many in government.

Indeed, the wealth of the baby boomer generation, which even now will be approaching retiring age, is predicated in no small measure on inflation, which has enhanced property values.

At present, the drivers of inflation appear muted – which may be why the Bank of England governor Mervyn King expressed surprise that inflation remained as strong as it is. Wage settlements are generally low and much of the runaway rises in commodity prices have come to a halt. But VAT did rise at the beginning of the year and is set to go up again as we welcome in 2011.

However, the big imponderable is the risk of imported inflation from, of all places, China. This populous nation has been suffering an unwelcome rise in its own cost of living indices, coupled with which their currency has also been rising. With China, now believed to be the world’s second-biggest economy having overtaken Japan, facing higher labour costs, charging more for their goods seems inevitable.

At the centre of China’s inflation problem lie rising labour costs. In a way, this is necessary if the nation is to maintain its economic development. The creation of a proper middle class in China is already well under way but, in Western terms, wages remain extremely low. Hourly rates in manufacturing industry are just one-tenth of those which apply in America, but nevertheless are now six times those of India.

In the seven years from the start of the new millennium, China succeeded in growing its exports to the US more than threefold. A modest setback did take place as the recession began to bite but China remains an important trading partner. Trade the other way also prospered, with American exports to China increasing by nearly five times between 2000 and 2008. Even so, they amounted to less than one quarter of China’s exports to the US.

All this goes to show that what happens in this fastgrowing region now has a real impact on us. A recent survey conducted by one of the leading investment banks concluded that businesses on both sides of the Atlantic were concerned that rising prices for goods imported from China would have an impact on margins, as the more austere conditions now present in consumer markets would make passing higher costs on difficult.

The view of the Bank of England is that, by 2012, inflation should have returned to the target set by the Government. The trick will be in finessing rate rises against rising economic activity, a difficult card to play. The worry is that inflation persists while the economy remains in the doldrums – so-called stagflation. We would all do well to keep an eye on inflationary trends in coming months – not just here, but in China, too.

Brian Tora is a consultant to investment managers, JM Finn & Co

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