Is inflation making a comeback?

Although the price of services has risen over the past few years, cheaper goods manufactured in China have had a deflationary impact on the British economy. But as Chinese wages begin to rise, UK inflation looks set to return.

There have been two inflation rates in Britain over the past few years, says Chris Giles in the FT. The price of services, such as restaurants or haircuts, have been accelerating at an annual rate of around 4%. But manufactured goods ranging from clothes to consumer electronics have been getting cheaper. So thanks to China's deflationary impact on goods cheap Chinese labour has allowed manufacturers to lower prices the overall inflation rate has stayed around the Bank of England's target of 2%.

But perhaps not for much longer, according to central bankers, including Bank of England governor Mervyn King. The Economist cites Jonathan Anderson of UBS, who says China's manufacturers are beginning to hike prices to improve their margins. Labour costs are also on the rise, with wages climbing at 10-15% a year; the minimum wage in Shenzhen, the area near Hong Kong, is set to jump by 20%. Higher commodity prices have also increased costs. Throw in China's inflationary effect on global commodity prices, and "the world's greatest price buster", as The Economist puts it, looks in danger of exporting inflation to the rest of the world. Recent UK data points in this direction: goods prices have been rising, rather than falling, over the past year, and import price inflation recently hit a ten-year high.

And just as worries over a revival of inflation are mounting, UK interest rates could be kept "artificially low", says George Trefgarne in The Daily Telegraph. Following the departure of ex-FT editor Richard Lambert and the hawkish economist David Walton, there are two vacancies on the Monetary Policy Committee. Chancellor Gordon Brown effectively controls it, and he may choose "a couple of cronies, who will parrot his fiction that inflation is the lowest since Nelson's time". The Consumer Price Index "is a fudge", says Trefgarne, as it concentrates on cheap manufactured goods and underrecords services. The current inflation rate, according to the CPI, is 2.2%, which will hardly ring true to those grappling with higher council tax and rises of up to 25% in gas bills. This is of real concern to pensioners; household bills now comprise 23% of retired people's disposable income, according to Norwich Union, which says inflation for pensioners reached 7.4% last year. Another index from the Bank of England suggests the public believes inflation is already ahead of the CPI at 2.7%, notes Trefgarne enough to wipe over 33% off the pound's purchasing power in a decade.

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Inflation and inflation expectations are also rising in the US.

In the first five months of the year, consumer prices rose at an annual rate of 5.2%, says Bloomberg. The core rate, which strips out food and energy, has climbed by 3.8% year-on-year over the past three months an 11-year high. "Inflation pressures are worldwide now," one analyst told Bloomberg. With higher energy prices seeping into the cost of services, the Federal Reserve is set to keep hiking rates to prevent inflation becoming embedded in the economy through a wage-price spiral an urgent task since the economy is weakening, which presages slower growth across the world. So there is a danger of stagflation, which as John Mauldin puts it on Investors Insight, would be "the absolute worst situation".

You may also like to read MoneyWeek editor Merrryn Somerset-Webb's article on why inflation is making a comeback. And see Jeremy Batstone of Charles Stanley's piece How big is the inflation threat really? for a global perspective on the inflation issue.